THE LIFE INSURANCE COURSE
TABLE OF CONTENTS
CHAPTER ONE - HISTORY & ELEMENTS OF LIFE INSURANCE ....................... 1
WHY LIFE INSURANCE .......................................................................................................................................3
LAW OF LARGE NUMBERS ...............................................................................................................................5
DETERMINING PREMIUM FOR LIFE INSURANCE .................................................................................6
PRICING ....................................................................................................................................................................7
YEARLY RENEWABLE TERM RATE CALCULATION ............................................................................8
RESERVE CALCULATION .............................................................................................................................. 11
FLEXIBLE PREMIUM PLANS ........................................................................................................................ 11
THE SAVINGS ELEMENT IN LIFE INSURANCE...................................................................................... 12
POLICIES THAT PARTICIPATE IN COMPANY EXPERIENCE – OR NOT ..................................... 13
NON-PARTICIPATING POLICIES ................................................................................................................. 13
PARTICIPATING POLICIES ........................................................................................................................... 14
DIVIDEND PAYMENT OPTIONS ............................................................................................................. 14
Cash Dividend ............................................................................................................. 14
Premium Reduction ...................................................................................................... 14
CURRENT ASSUMPTION POLICIES ............................................................................................................ 15
Chapter 1 .................................................................................................................................................................... 16
CHAPTER TWO - THE INSURANCE CONTRACT ................................................. 19
CHARACTERISTICS OF LIFE INSURANCE CONTRACTS .................................................................... 20
ELEMENTS OF A CONTRACT ....................................................................................................................... 21
EFFECTIVE DATE ............................................................................................................................................. 22
CONSIDERATION ............................................................................................................................................. 23
CONTRACT FOR LEGAL PURPOSES .......................................................................................................... 23
INSURABLE INTEREST ................................................................................................................................... 23
THE APPLICATION ............................................................................................................................................. 24
CONCEALMENT, MISREPRESENTATION, FRAUD ................................................................................ 24
PRESUMPTION OF DEATH ............................................................................................................................ 25
INCONTESTABLE CLAUSE ........................................................................................................................... 26
SUICIDE CLAUSE ............................................................................................................................................. 26
GRACE PERIOD ................................................................................................................................................. 27
DELAY PROVISION .......................................................................................................................................... 27
EXCLUSIONS...................................................................................................................................................... 28
AVIATION ...................................................................................................................................................... 28
WAR EXCLUSION ........................................................................................................................................ 28
BENEFICIARY PROVISION ............................................................................................................................ 28
BENEFICIARY DESIGNATIONS ................................................................................................................... 29
PRIMARY BENEFICIARY ...................................................................................................................... 29
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CONTINGENT BENEFICIARY.............................................................................................................. 29
REVOCABLE BENEFICIARY DESIGNATION ................................................................................. 29
IRREVOCABLE BENEFICIARY DESIGNATION ............................................................................. 29
NAMING THE BENEFICIARY .............................................................................................................. 30
PER CAPITA .............................................................................................................................................. 30
PER STIRPES ............................................................................................................................................. 30
MINORS, TRUSTS AND ESTATES ...................................................................................................... 31
Uniform Simultaneous Death Act .................................................................................. 31
Common Disaster Provision .......................................................................................... 32
NON-FORFEITURE PROVISION .................................................................................................................. 32
NON-FORFEITURE OPTIONS .................................................................................................................. 33
CASH SURRENDER ................................................................................................................................. 33
PAID-UP INSURANCE ............................................................................................................................ 33
EXTENDED TERM INSURANCE ......................................................................................................... 34
Chapter 2 ............................................................................................................................................................ 34
CHAPTER THREE – THE INSURANCE CONTRACT II ........................................ 38
SETTLEMENT OPTIONS ................................................................................................................................. 38
LUMP SUM ..................................................................................................................................................... 38
INTEREST ONLY .......................................................................................................................................... 38
FIXED AMOUNT ........................................................................................................................................... 39
FIXED PERIOD .............................................................................................................................................. 39
LIFE INCOME ................................................................................................................................................ 40
CASH/INSTALLMENT REFUND ANNUITY .......................................................................................... 40
LIFE INCOME OPTION WITH PERIOD CERTAIN .............................................................................. 40
JOINT AND SURVIVORSHIP OPTION .................................................................................................... 41
OTHER OPTIONS .......................................................................................................................................... 41
Educational Option....................................................................................................... 41
Flexible Spending Account ........................................................................................... 41
Individualized Options ................................................................................................. 41
ASSIGNMENTS .................................................................................................................................................. 41
ABSOLUTE ASSIGNMENT .................................................................................................................... 42
VIATICAL SETTLEMENTS ........................................................................................................................ 42
COLLATERAL ASSIGNMENT ................................................................................................................... 43
POLICY LOANS ................................................................................................................................................. 43
COLLATERAL ............................................................................................................................................... 43
INTEREST ....................................................................................................................................................... 44
DIRECT RECOGNITION ............................................................................................................................. 44
INTEREST PAID ON BORROWED VALUES ......................................................................................... 45
LOAN REPAYMENT .................................................................................................................................... 45
REINSTATEMENT CLAUSE ........................................................................................................................... 45
MISSTATEMENT OF AGE ............................................................................................................................... 46
RENEWAL PROVISIONS ................................................................................................................................. 47
OPTIONAL RIDERS/BENEFITS ...................................................................................................................... 47
WAIVER OF PREMIUM ................................................................................................................................... 47
Payor Rider .................................................................................................................. 48
Premium Waiver and Universal Life ............................................................................. 48
Accidental Death .......................................................................................................... 48
Accidental Death and Dismemberment .......................................................................... 49
Loss
Amount Paid ........................................................................................................ 49
Disability Income Rider ............................................................................................... 49
ACCELERATED DEATH BENEFIT RIDER ............................................................................................ 50
Terminal Illness ........................................................................................................... 50
Catastrophic Illness ...................................................................................................... 50
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Long Term Care Coverage ............................................................................................ 50
GUARANTEED INSURABILITY.................................................................................................................... 51
COST OF LIVING RIDER (COLA) ............................................................................................................ 51
TERM RIDER.................................................................................................................................................. 52
Chapter 3 ............................................................................................................................................................ 52
CHAPTER FOUR - TRADITIONAL LIFE INSURANCE ......................................... 56
TERM LIFE INSURANCE POLICIES ............................................................................................................. 56
RENEWABLE TERM POLICIES ..................................................................................................................... 56
LEVEL PREMIUM POLICIES ......................................................................................................................... 57
VARYING FACE AMOUNT TERM INSURANCE ...................................................................................... 58
ENDOWMENT INSURANCE ............................................................................................................................. 59
WHOLE LIFE INSURANCE ............................................................................................................................... 59
ORDINARY LIFE INSURANCE ........................................................................................................................ 60
LIMITED PAYMENT WHOLE LIFE .............................................................................................................. 61
CURRENT ASSUMPTION WHOLE LIFE INSURANCE ........................................................................... 62
CAWL Low-premium Plan ........................................................................................... 63
CAWL High-premium Plan ........................................................................................... 63
MODIFIED LIFE INSURANCE ....................................................................................................................... 64
“ENHANCED” LIFE INSURANCE ................................................................................................................. 64
GRADED PREMIUM WHOLE LIFE .............................................................................................................. 65
DEBIT INSURANCE .......................................................................................................................................... 65
FAMILY POLICY ............................................................................................................................................... 66
JUVENILE INSURANCE .................................................................................................................................. 66
BURIAL INSURANCE....................................................................................................................................... 67
MULTIPLE LIFE INSURANCE POLICIES ................................................................................................... 67
DISINTERMEDIATION ....................................................................................................................................... 68
REPLACEMENT QUESTIONNAIRE ......................................................................................................... 69
GROUP LIFE INSURANCE ................................................................................................................................ 70
GROUP INSURANCE REQUIREMENTS ...................................................................................................... 70
Chapter 4 ............................................................................................................................................................ 74
1B 2A 3B 4A 5C 6B 7C 8A 9B 10A 11C 12B 13A 14B 15A 76
CHAPTER FIVE - INTEREST SENSITIVE LIFE INSURANCE ............................. 77
VARIABLE LIFE INSURANCE ......................................................................................................................... 77
MARKET SHARE OF VLI ................................................................................................................................ 79
ADVANTAGE OF VLI ...................................................................................................................................... 80
UNIVERSAL LIFE................................................................................................................................................. 81
DEATH BENEFITS ............................................................................................................................................ 83
An Adjustable Death Benefit ........................................................................................ 83
Death Benefit Options: ................................................................................................. 83
OPTION A ....................................................................................................................................................... 83
OPTION B ......................................................................................................................................................... 84
THE CASH VALUE ACCOUNT ...................................................................................................................... 84
CHARGES TO THE ACCOUNT ................................................................................................................. 84
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SINGLE PREMIUM UNIVERSAL LIFE ........................................................................................................ 85
THE ADJUSTABLE PREMIUM ...................................................................................................................... 85
THE IMPORTANCE OF PREMIUM FLEXIBILITY.................................................................................... 86
INCREASING THE PREMIUM PAYMENT ............................................................................................. 86
USES FOR THE CASH VALUE ACCOUNT ................................................................................................. 87
VARIABLE UNIVERSAL LIFE ......................................................................................................................... 90
FEATURES OF THE VARIABLE UNIVERSAL LIFE POLICY ............................................................... 90
STANDARD PROVISIONS .......................................................................................................................... 92
Grace Period ............................................................................................................................................... 92
Reinstatement ............................................................................................................................................. 92
Free-Look Provision .................................................................................................................................. 92
Conversion Privilege ................................................................................................................................. 92
Annual Report ............................................................................................................................................. 92
Riders & Options Available ..................................................................................................................... 93
MODIFIED ENDOWMENT CONTRACTS ............................................................................................... 93
Using a MEC ............................................................................................................................................... 94
TAXATION AND REGULATION ................................................................................................................... 95
1. Cash Value Accumulation Test ........................................................................................................... 95
2. The Corridor Test .................................................................................................................................. 96
3. The Seven-pay Test ............................................................................................................................... 96
CORRIDOR RATIO ..................................................................................................... 97
NASD CONDUCT RULES ................................................................................................................................ 98
ILLUSTRATIONS............................................................................................................................................. 98
SPECIAL NASD CONDUCT RULES REGARDING VARIABLE CONTRACTS ............................. 99
USES FOR VARIABLE UNIVERSAL LIFE INSURANCE ...................................................................... 100
THE ATTRACTIVENESS OF VUL ............................................................................................................... 101
Chapter 5 .......................................................................................................................................................... 102
CHAPTER SIX - TAXATION OF LIFE INSURANCE ............................................ 105
INCOME TAX ....................................................................................................................................................... 105
PREMIUMS ........................................................................................................................................................ 105
DEATH BENEFITS .......................................................................................................................................... 105
TRANSFER FOR VALUE RULE .............................................................................................................. 106
IRC SECTION 7702 DEFINITION OF LIFE INSURANCE ..................................................................... 106
OTHER CAUSES FOR PROCEEDS TO BE TAXED ............................................................................ 107
Alternative Minimum Tax........................................................................................... 108
TAXES ON SETTLEMENT OPTIONS .................................................................................................... 108
TAXATION OF LIVING PROCEEDS .......................................................................................................... 108
MODIFIED ENDOWMENT CONTRACT (MEC) ................................................................................. 108
DIVIDENDS .................................................................................................................................................. 109
CASH VALUE .............................................................................................................................................. 109
SECTION 1035 POLICY EXCHANGES .................................................................................................. 109
MATURED ENDOWMENTS ..................................................................................................................... 110
POLICY LOANS .......................................................................................................................................... 110
ACCELERATED DEATH BENEFIT TAXATION ................................................................................. 111
ANNUITIES .................................................................................................................................................. 111
FEDERAL ESTATE TAX .................................................................................................................................. 111
Annuities ................................................................................................................... 112
Joint Owned Property ................................................................................................. 113
Tenancy by The Entirety ............................................................................................ 113
Tenancy in Common ................................................................................................... 113
Community Property .................................................................................................. 113
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Power of Appointment ................................................................................................ 113
Life Insurance in the Gross Estate ............................................................................... 114
Taxable Estate ........................................................................................................... 114
GIFT TAX ...................................................................................................................................................... 115
Gifts of Insurance ...................................................................................................... 115
GENERATION-SKIPPING TRANSFER TAX ........................................................................................ 116
ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION ACT 2001 .................................... 116
PRINCIPAL FEATURES ................................................................................................................................... 116
INCREASE OF EXEMPTIONS ...................................................................................................................... 117
ESTATE AND GST TAX RATES .................................................................................................................. 117
REPEAL OF TAXES ........................................................................................................................................ 118
GIFT TAX EXEMPTION AND RATES ........................................................................................................ 118
STEP-UP BASIS IN ESTATES ...................................................................................................................... 119
CREDIT FOR DEATH TAXES AT THE STATE LEVEL ......................................................................... 120
DEDUCTION ALLOWED FOR STATE .................................................................. 120
DEDUCTION FOR FAMILY OWNED BUSINESS .................................................................................... 120
ANNUAL GIFT TAX EXCLUSION .............................................................................................................. 120
CAPITAL GAINS EXEMPTION .................................................................................................................... 121
Chapter 6 .......................................................................................................................................................... 121
Answers to Chapter Six Study Questions ........................................................................... 123
CHAPTER SEVEN – LIFE INSURANCE IN FINANCIAL & ESTATE PLANNING
.................................................................................................................................... 124
DETERMINING FINANCIAL OBJECTIVES.............................................................................................. 125
Cash Objectives ......................................................................................................... 125
Income Objectives ...................................................................................................... 125
ESTATE PLANNING ....................................................................................................................................... 126
DISPOSITION OF PROPERTY AT DEATH........................................................................................... 126
Probate ...................................................................................................................... 126
Nature of property ownership ..................................................................................... 126
Contract ..................................................................................................................... 126
By Law ...................................................................................................................... 126
WILLS ............................................................................................................................................................ 126
TRUSTS .............................................................................................................................................................. 127
BASIC TRUSTS ............................................................................................................................................ 127
Marital Trusts ............................................................................................................ 127
Qualified Terminable Interest Property trust (QTIP) .................................................... 128
Bypass Trust .............................................................................................................. 128
Trust for Minor Children ............................................................................................ 128
Crummey Trust .......................................................................................................... 129
IRREVOCABLE LIFE INSURANCE TRUSTS ...................................................................................... 129
Charitable Remainder Trusts....................................................................................... 130
Using Life Insurance with CRT .................................................................................. 130
USING TRUSTS UNDER EGTRRA 2001 .................................................................................................... 131
REVIEW EXISTING ESTATE PLAN ........................................................................................................... 132
THE EFFECT OF THE EXPIRATION PROVISION .................................................................................. 133
THE EFFECT OF DYING UNDER THE TAX ACT ................................................................................... 133
THE ROLE OF LIFE INSURANCE WITH THE TAX ACT ..................................................................... 134
APPLICATION OF STEP-UP IN BASIS AFTER 2010 ............................................................................. 135
INCOME IN RESPECT TO A DECEDENT ................................................................................................. 136
SUMMARY OF BENEFITS OF LIFE INSURANCE FOR PLANNING ................................................. 136
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Chapter 7 .......................................................................................................................................................... 137
1C 2A 3C 4B 5C 6A 7B 8C 9C 10C 11A 12B 13B 14C 15A .............. 139
CHAPTER EIGHT - BUSINESS USES OF LIFE INSURANCE ........................... 140
BUSINESS CONTINUATION ........................................................................................................................... 140
CLOSELY HELD FIRMS .................................................................................................................................... 140
SOLE PROPRIETORSHIPS ....................................................................................................................... 141
PARTNERSHIPS .......................................................................................................................................... 141
BUY-AND-SELL AGREEMENTS ............................................................................................................ 142
Entity Approach ......................................................................................................... 143
Cross-purchase Approach ........................................................................................... 143
TAXATION OF PARTNERSHIP BUY-AND-SELL AGREEMENTS ................................................ 143
CLOSELY HELD CORPORATIONS ........................................................................................................ 144
Death of a Majority Stockholder ................................................................................. 144
Death of a Minority Stockholder ................................................................................. 145
CORPORATE BUY-AND-SELL AGREEMENTS.................................................................................. 145
Taxation of Corporate Buy-and-Sell Agreements ......................................................... 145
CROSS-PURCHASE vs STOCK REDEMPTION AGREEMENTS ..................................................... 146
TAXATION ............................................................................................................................................... 146
STOCK REDEMPTIONS UNDER SECTION 303 ................................................................................. 147
MISCELLANEOUS CONCERNS .............................................................................................................. 148
KEY EMPLOYEE INSURANCE ...................................................................................................................... 148
PERMANENT LIFE INSURANCE ........................................................................................................... 149
TERM LIFE INSURANCE .......................................................................................................................... 149
SALARY CONTINUATION PLAN .......................................................................................................... 150
DEATH BENEFIT ONLY LIFE INSURANCE PLAN ........................................................................... 150
SPLIT-DOLLAR LIFE INSURANCE ....................................................................................................... 150
Reverse Split-Dollar Plan ........................................................................................... 151
Collateral Assignment System .................................................................................... 152
Choosing the Best Method of Split-Dollar Plan ........................................................... 153
MISCELLANEOUS USES OF SPLIT-DOLLAR PLANS ..................................................................... 154
Sole Proprietor ........................................................................................................... 154
Cross-Purchase Buy-and-Sell Agreement .................................................................... 154
Family Split-Dollar Plan ............................................................................................. 155
EXECUTIVE BONUS PLAN .......................................................................................................................... 155
Chapter 8 .......................................................................................................................................................... 156
1B 2C 3B 4C 5A 6B 7A 8C 9A 10A ................................................... 157
CHAPTER NINE - UNDERWRITING ...................................................................... 158
ADVERSE SELECTION .................................................................................................................................. 159
UNDERWRITING FACTORS......................................................................................................................... 160
AGE ................................................................................................................................................................. 160
SEX ................................................................................................................................................................. 160
PHYSICAL CONDITION ........................................................................................................................... 161
BUILD ........................................................................................................................................................ 161
ABNORMALITIES .................................................................................................................................. 161
PERSONAL HEALTH HISTORY......................................................................................................... 161
FAMILY HISTORY ................................................................................................................................ 162
TOBACCO USE ....................................................................................................................................... 162
FINANCIAL CONDITION .................................................................................................................... 163
ALCOHOL AND DRUGS ...................................................................................................................... 163
OCCUPATION ......................................................................................................................................... 164
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AVOCATIONS ......................................................................................................................................... 164
MILITARY SERVICE ............................................................................................................................. 164
UNDERWRITING INFORMATION ............................................................................................................... 165
APPLICATIONS ...................................................................................................................................... 165
PHYSICAL EXAMINATION ................................................................................................................ 166
LABORATORY TESTS .......................................................................................................................... 166
ATTENDING PHYSICIANS’ STATEMENTS ................................................................................... 166
INSPECTION COMPANIES .................................................................................................................. 167
DATABASES – MEDICAL INFORMATION BUREAU (MIB) ..................................................... 168
CLASSIFICATION PROCESS ................................................................................................................... 169
THE RATING SYSTEM .............................................................................................................................. 170
RATING IMPAIRED RISKS ...................................................................................................................... 171
RATING PROCEDURES OF IMPAIRED RISKS ............................................................................. 172
FLAT EXTRA PREMIUM .......................................................................................................................... 173
MISCELLANEOUS RATING SYSTEMS ................................................................................................ 174
UNINSURABILITY ..................................................................................................................................... 174
REINSURANCE ................................................................................................................................................ 175
RETENTION ................................................................................................................................................. 176
TYPES OF REINSURANCE ...................................................................................................................... 177
PROPORTIONAL REINSURANCE ..................................................................................................... 177
NONPROPORTIONAL REINSURANCE ............................................................................................ 177
stop-loss reinsurance .............................................................................................................................. 177
CATASTROPHE REINSURANCE ....................................................................................................... 178
SPREAD-LOSS REINSURANCE ......................................................................................................... 178
REINSURANCE CONTRACTS ................................................................................................................. 178
FACULTATIVE TREATY ..................................................................................................................... 178
AUTOMATIC TREATY ......................................................................................................................... 178
FACULTATIVE OBLIGATORY .......................................................................................................... 179
REINSURANCE PLANS ................................................................................................................................. 179
YEARLY RENEWABLE TERM (YRT) ................................................................................................... 179
COINSURANCE ........................................................................................................................................... 180
MODIFIED COINSURANCE ..................................................................................................................... 180
ASSUMPTION REINSURANCE ............................................................................................................... 180
SURPLUS RELIEF ....................................................................................................................................... 181
Chapter 9 .......................................................................................................................................................... 182
CHAPTER TEN - INSURANCE REGULATION AND ORGANIZATION ............. 185
FEDERAL REGULATION ................................................................................................................................ 186
STATE REGULATION ....................................................................................................................................... 188
THE NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC) ............................. 188
SUPERVISION BY STATE REGULATIONS ............................................................................................. 189
FINANCIAL REGULATION ..................................................................................................................... 192
Reserves .................................................................................................................... 193
LIFE AND HEALTH GUARANTY ASSOCIATIONS ............................................................................... 194
TAXATION OF LIFE INSURANCE COMPANIES .................................................................................... 194
FEDERAL TAXATION .................................................................................................................................... 195
TAXATION OF DIVIDENDS ......................................................................................................................... 196
LIFE INSURANCE COMPANY ORGANIZATION ................................................................................... 197
STOCK INSURERS .......................................................................................................................................... 198
MUTUAL INSURERS ...................................................................................................................................... 198
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HOLDING COMPANIES ................................................................................................................................. 199
OUTSOURCING ................................................................................................................................................ 200
HOME OFFICE ORGANIZATION ................................................................................................................ 200
Board of Directors...................................................................................................... 200
Executive Officers ..................................................................................................... 201
Actuarial .................................................................................................................... 201
Marketing .................................................................................................................. 201
Accounting ................................................................................................................ 201
Investment ................................................................................................................. 201
Legal ......................................................................................................................... 202
Underwriting .............................................................................................................. 202
Administration ........................................................................................................... 202
Policyowner Service ..................................................................................................................... 202
Claims Administration .............................................................................................................. 202
Information Systems ................................................................................................................. 202
Human Resources ...................................................................................................................... 203
MARKETING ..................................................................................................................................................... 203
Marketing Intermediaries ............................................................................................ 203
Agency-Building Distribution ..................................................................................... 204
Brokers ...................................................................................................................... 204
Personal-Producing General Agents ............................................................................ 205
Independent Non-life Agents ...................................................................................... 205
Large Producer Groups ............................................................................................... 205
Financial Institutions .................................................................................................. 205
Direct Response ......................................................................................................... 206
THE FUTURE OF LIFE INSURANCE .......................................................................................................... 206
Chapter 10 ........................................................................................................................................................ 209
GLOSSARY ................................................................................................................ 212
BIBLIOGRAPHY ......................................................................................................... 242
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CHAPTER ONE - H ISTORY & ELE ME NTS OF L IFE IN S URANCE
As with many of the institutions of the civilized world, life insurance can be traced
back to a Greek heritage, even though some scholars attribute the origin of life
insurance to the Code of Hammurabi, about 1750 B.C., which provided for the state to
pay indemnity for the murder of a member of the household, by a robber. The Greek
societies, basically religious groups which flourished around 500 B.C. to 200 B.C.,
provided a fund for burial as it was believed that the departed could gain entrance into
what they conceived as their “heaven” through a system of rituals, feasts and sacrifices
to their gods. Obviously, this was expensive, so the fund was created to offset these
final expenses.
The Roman “collegia”, which was similar to the Greek societies, gradually became
mutual benefit associations and had specific benefits and operated from membership
contributions. These associations ceased to exist after the decline of the Roman empire.
However, the need for such societies/organizations continued and were followed by
“Guilds” which while being organized for religious, social and economic reasons, did
provide relief for several perils, such as shipwreck, loss of home by fire, loss of tools
used to make a living, etc. While these guilds originated primarily in England, t hey
also were present in Japan as Craftsmen’s guilds from the end of the 1600’s until nearly
1900.
The English created the English Friendly Societies, which were actually mutual benefit
groups and while they were not concerned with trade, religious or sim ilar groups, they
provided some death or burial fund benefit. They were funded by assessments, but
since they were not constructed on any scientific or actuarial basis, the financial
burdens evolved to the younger members, who, being mostly in good health , dropped
out of the plan. Therefore, some private insurance companies were formed, failed, and
formed again, but they were all the ancestors of the true life insurance concept.
The earliest insurers were wealthy individuals who either alone, or with a c onsortium of
other wealthy persons, assumed insurance risks. They were for short duration, and were
used for such situations as the voyage of ships. Of course, life insurance could not be
written in this fashion as the insured could possibly outlive the i nsurers. Incidentally,
the insurers would sign their name(s) under the amount of the risk that they were
agreeing to bear, hence they were called “underwriters.”
The earliest life insurance contract on record was written in 1583 for a period of 12
months, on the life of a William Gybbons, for a premium of 75 pounds, with a “face
amount” of over 383 pounds. Interestingly, the insured died just before the end of the
year, but the underwriters refused to pay because they insisted that their payments were
1
based on “lunar months” (which are longer than calendar months). The English courts
would have nothing to do with that, so the underwriter(s) paid.
The first true mutual insurance company for life insurance was The Life Assurance And
Annuity Association, established in 1699, which went out of business 46 years later.
Then the Amicable Society for a Perpetual Assurance Office was formed, which did not
offer a stated death benefit, but operated more as a “tontine” (described below).
Around 1720, two English insurers which were stock companies, created a monopoly on
British insurance, but when The Equitable applied for a charter in 1761 and it was
denied, they formed a mutual company (which did not require a charter). The Equitable
is considered as the first life insurance company that operated on a modern insurance
basis.
The modern life insurance company had its origins in Europe, and the Equitable was
followed by The Globe in 1803, and other companies in France in the late 1700’s and
early 1800’s. The first stock life insurer in Germany was formed in 1828, and The
Prudential (U.K. company), formed in 1848 was the first company to introduce
industrial insurance about 1850.
As is typical with many industries in Europe, the government and the insurers were
intertwined in many ways, and some governments used the insurers as a means to raise
funds for government expenditures. One of these systems was the French system of
“tontines” and in the past, some new insurance operations were compared to tontines .
In the late 1600’s, King Louis XIV of France used an annuity scheme to raise funds for
the government, which the government needed very badly at that time. This scheme
was created by a nobleman, one Lorenzo Tonti (from which comes, tontine). It worked
as follows:
All participants would contribute a specified sum each year, and from these
“payments”, a sum was set aside each year to purchase an annuity for life to those
who participated in the tontine. As the participants died off and their payments
were no longer being received by the other participants, the amount of the
annuities grew every year, and was available to the survivors. Therefore, the
longer one lived, the larger the amount of the annuity that was paid out to the
survivors.
Later, other governments and some private firms used the tontine scheme, until it was
outlawed in the early 20 th century.
In the early colonial years in the United States, the English insurers had a monopoly,
and there were few, if any, colonials that were wealthy enough to compete as individual
underwriters. However, before the Civil War, some English “orders”, such as the Odd
Fellows and the Foresters, were introduced into the U.S. and they exerted a strong
fraternal influence at that time.
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The first mutual life insurer in the U.S. was the Corporation for the Relief of the Poor
and Distressed Presbyterian Ministers and for the Poor and Distressed Widows and
Children of Presbyterian Ministers, founded in Philadelphia in 1759. (Imagine
representing this company at a convention – the sheer size name tag would be
impressive!) This company incidentally, is now part of the Provident Mutual Life
Insurance Co. Mutual of New York (MONY) was formed in 1842 and other mutual
insurers were formed until the state of New York in 1849 required all insurers to place a
security deposit of $100,000 with the State insurance department. This move was
instigated by the established mutuals and effectively stopped the creation of new
mutuals.
The first stock insurer was Insurance Company of North America, chartered in 1794,
basically to sell annuities, and 10 years later it had only sold 6 life insurance policies,
so it closed the doors on its life insurance business. The first company in the U.S. that
sold a decent amount of life insurance was The Pennsylvania Company for the
Insurance on Lives and Granting Annuities, chartered in 1812, discontinuing its
business 60 years later.
The Prudential Insurance Company of America introduced industrial life insurance in
1875, followed by John Hancock and Metropolitan Life. The marketing of industrial
life insurance had probably the greatest influence on the public awareness of life
insurance in the United States.
W H Y L I FE I N S U R A N C E
While it may seem rather cold economists have recognized for many years that there is
an economic value to a human life and that these values are an important and necessary
part of the nation’s economic wealth. The marketplace universally acknowledges
investment in the human personal development, so any imp rovement in this investment
is recognized as increases in income and/or wages. Therefore, any increase in earnings
is simply an increase in the yield in an investment. For instance, those with college
degrees traditionally make more money than those without such degrees, therefore this
difference in income can be considered as a return of the investment in education.
For centuries, from the Code of Hammuabi, and throughout the religious texts such as
the Bible and the Koran, and especially in early Anglo -Saxon law, there have been
established methods of determining compensation given to a relative of an individual
who was killed by a third party. Today, the value of a human life taken by a third
party, and the recovery for wrongful death is in the news continually, with libraries full
of books on wrongful death situations, cases and laws - it is a very large and important
part of Liability insurance.
For the purpose of Life Insurance, the computation of the value of a human life takes a
more scientific approach, as contrasted with the legalistic approaches used to determine
3
how much money a surviving relative is awarded. The impact of and the importance of
punitive damages is more properly discussed in books on liability and property and
casualty insurance.
It is difficult to determine the value of a human life for insurance purposes, as every
human life is unique and some, if not many, believe that it is not appropriate to attempt
to place a monetary value on human life in any event because society do es not condone
the sale of a human life. Therefore, it is important to stress that the “Human Life
Value” concept is a method of placing a value on the services of a person’s life . This
is not unaccepted or immoral; indeed the ownership of a person’s lif e itself is what is
unaccepted and immoral.
The “Human Life Value” concept was first introduced in the 1920’s, but as any
Chartered Life Underwriter (CLU) can attest, in 1942, S.S. Huebner proposed this
concept as a philosophical framework for analyzing certain economic risks that
individuals face. Without going into the qualitative and quantitative considerations of
the Human Life Value concept, this concept recognizes that a human life is subject to 4
types of losses: premature death, incapacity (disability); retirement and unemployment.
Since any of these losses can affect an individual’s earning capacity, there is a resultant
negative impact on their human life value.
Even though the probability of loss from death or disability is considerably greate r than
from any other commonly insured peril, people still generally purchase property
insurance and avoid purchasing life (or disability) insurance. When life insurance is
purchased, it is usually for an inadequate (sometime insignificant) amount.
The human life value concept is highly recommended for a serious student of Life
Insurance. A general feeling for this concept can be obtained by recognizing Dr.
Huebner’s “Human Life Value Admonitions.”
1. The human life value should be carefully “appraised and capitalized.” For those
who earn more than is necessary to individually maintain their own lifestyle, the
excess amount is of value to those who are dependent upon it (generally this is the
family). The present value of this excess earnings creates an economic basis for life
(& health) insurance.
2. “The human life value is the creator of property values, i.e., the human life value is
the cause and property values are the effect.”
3. “The family is an economic unit which is organized around the human life values of
its members.” The “family” per se, needs to be treated just like any other business
and its organization and management, and eventual discontinuance, in the same
manner that a business would go through these phases.
4. “The human live value and the protection it affords must be considered as the
principal (economic) link between the present and succeeding generations.” The
4
earnings of the breadwinner(s) create the funds and the foundation for the proper
education and development of the children in case the breadwinner(s) are unable to
fulfill that role because of death or disability.
5. Because of the significance of the human life value, the areas affecting the
successful operation of a business must be used to life values as well, such as
appraisal, indemnity and even depreciation.
L AW O F L A R GE NU MB E RS
The entire function of insurance of any type is to guard against financial conclusions of
perils by having the losses of those who suffer from the effect of these perils, paid by
the contributions of many that are concerned that they will also suffer from the effects
of these perils. To be concise, this is “insurance in a nutshell” – sharing of losses.
Insurance relies upon the effects of the laws of large numbers to reduce the speculative
element of insurance, and to compensate for fluctuations in losses. Simply put, the law
of large numbers that applies to life insurance states that the larger the number of those
insured against premature death, the less the loss experience will “deviate” from th e
expected loss experience.
This law of large numbers does not mean that losses to particular insureds will be more
easily predicted, it simply means that the more persons insured, the more the loss
experience can be predicted, all things being equal.
If a single person is insured for $1,000, this would be a gamble; and if the number is
increased to 100, then there still is a gamble. However if half a million persons are
insured for $1,000, anticipated death rates will vary from actual death rates by no more
than one percent. Theoretically, if the number of lives insured on the same basis were
of sufficient number so that the law of large numbers would be exactly predictable, then
there would be no uncertainty in the estimating losses during a given period of time,
barring catastrophes such a war, terrorist attacks, mad -cow diseases, or other epidemics.
The major difference between life insurance and non-life insurance, is that the peril
insured against, premature death, is an uncertainty for a year, and each year thereafter.
However, the probability of death will increase until it is a virtual certainty – everyone
dies at some time or other. (It is a “virtual” certainty as it is possible for a person to
outlive the insurance policy – for instance a person who lives past age 100 will have
outlived the mortality tables). Therefore, if a life insurance policy is to protect an
individual throughout the lifetime of the individual, a fund must be generated to meet a
claim that is certain to occur. (Even a person age 101 will receive the fund, one way or
the other).
5
Many persons consider insurance as “gambling”, particularly with life insurance, where
they believe that the insurance company is simply gambling that they will die
prematurely. A very important principle of insurance is as follows:
 Insurance transfers an existing exposure and, through the pooling of similar loss
exposures, reduces risk.
Another definition widely accepted:
 Life insurance is a device to spread the cost of financial loss resulting from
death from an individual to a group through an insurance company by
transferring the cost so the financial loss to any one individual is small.
Make no mistake; however, insurers much prefer that their insured do not suffer the loss
for which they are insured. In life insurance such losses are inevitable, and the insurer
plans for such losses within the premium structure.
D E T E R MI N I N G P R E MI U M FO R L I FE I N S U R A N C E
Premiums for insurance should always meet three criteria; they must be adequate,
reasonable (or equitable), and should not be excessive.
First, premiums must be adequate in order for the insurance company to provide the
benefits contracted with an individual under the contract with the insurer (the policy).
Obviously, if the premiums are not adequate then the insurance company will
eventually not be able to pay the claims to the insured, so everyone suffers.
Secondly, the premium must be reasonable (or equitable) and the insurance company
should not be able to earn an excessive profit. The pursuit of equity is one of the goals
of underwriting (discussed in more detail later in this text) and equitable treatment of
insureds is accomplished by rating factors such as age, sex, plan, health and benefits
provided.
And lastly, the premiums must not be unfairly discriminatory or inequitable. There are
different interpretations of “inequitable,” for example; some feel that it is not
acceptable to charge different life (and health) insurance rates to men and women who
are otherwise identically situated. One of the strongest forces that keep premiums from
becoming excessive is simply that of competition.
Theoretically, one could say that each insurance applicant should pay an exclusive
(unique) premium to reflect a different expectation of loss, but this would be
impractical (imagine agents having to carry a huge rate manual everywhere). So,
classifications are established for applicants to be grouped together according to similar
expectation of loss. Statistical studies of a large number of nearly homogeneous
6
(similar or identical in nature or form) exposures in each underwriting classification
enable the projection of losses after adjustments for future inflation and statistical
irregularities. These adjusted statistics are used to calculate the pure cost of protection,
or pure premium, to which the insurance company adds on “loadings” for agent
commissions, premium taxes, administrative expenses, contingency reserves, other
acquisition costs and profit margin. The result is the gross premium that is charged to
the insured.
PRICI NG
The pricing of life insurance is a complex, technical and methodical procedure,
performed by actuaries who are arguably the most technically educated professionals in
the insurance industry. Therefore it is completely outside the purview of this text to
discuss in detail the actual pricing procedure. However, in order to understand life
insurance, it is necessary to understand certain elements of pricing life insurance and
how they apply to the determination of life insurance premiums.
It is generally acknowledged that in order to determine the insurance premium (and
reserves) there must be information and assumptions available regarding four elements:
(1) the probability of the insured event happening; (2) the time value of money; (3) the
benefits of the contract; and (4) loadings.
Before the insurer can determine the amount of the premium to be charged to each
insured, the probability of losses for the group as a whole must be determined. In life
insurance, these probabilities are shown on a yearly basis as mortality tables. (For
health insurance, morbidity tables show yearly probabilities of loss.) These tables are
the very foundation of life (or health) pricing.
Other important factors in pricing includes the fact that those people who purchase life
insurance are not all of the same age, and obviously, younger people have a less likely
chance to die in the early years than older persons. Therefore premiums rates should be
higher for older persons than for the younger persons.
Another factor is that life (and health) insurance companies require that premiums be
paid in advance, and for policies of longer maturity, the portion of the premium that is
not needed to cover immediate benefits is invested to fund future expected benefits and
expenses.
Other important items must be taken into consideration, for instance the amount of
coverage, the level of coverage, etc., and very importantly, the recognition that some
policies will remain in force longer than others – this is called persistency.
There are a wide variety of policies sold, as later discussions will reveal, as some insure
against death or disability for a certain number of years or for the whole of life and
premiums may be paid for a short period of time, or for the length of coverage. With
some policies premiums are fixed, with some they vary according to the wishes and
7
needs of the policyowner, or vary with the tem of the policy. Some policies pay a
single sum at death or maturity; others pay a benefit over a period of years. There are
obviously many differences, and each type of policy will have its own statistics.
There is one important factor when discussing life insurance premiums: unlike other
kinds of insurance, the life insurance policy cannot be cancelled and can extend for a
long period of time.
Net rates are calculated to recognize the probability of the insured event, the time value
of the money, and the benefits of the contract. When expenses and other loadings are
added to the net rates, then they become Gross rates.
Practically speaking, companies frequently do not develop new net rates for new
products introduced, especially if there are similar products already in the marketplace.
The rates on those plans will be analyzed by the actuaries to determine if those
premiums meet the company’s objectives and profit requirements. If not, the premiums
will be so adjusted. If it is discovered that the rates are higher than those needed by the
profit requirements of the company, the rates could be adjusted downward. If they are
inadequate, then the actuaries will have to determine if they (1) want to develop such a
product for their own sales force; (2) if they want to maintain a comparative premium
so that their sales force can be competitive, even if the premiums do not quite match the
company’s objectives; or (3) if benefits can be changed in such a fashion so that the
price will be competitive, but certain benefits may be different or less.
Of course, the actuaries may determine the gross premiums by using what is considered
as a realistic interest, mortality, expense, taxes and persistency assumptions and with
the company objectives and profit margin intact.
YEARLY RENEW ABLE TERM RATE CALCULATION
As stated earlier, it is entirely beyond the purview of this text to go into detail as to rate
calculation; however the calculation of the premium for a Yearly Renewable Term
(YRT) policy, the simplest term insurance policy, can be understood and is quite
illustrative.
An YRT policy provides coverage for a period of one year only, but allows the
policyowner to renew the policy at the end of each year, even if the policyowner suffers
poor health. Therefore, each year’s premium pays the policy’s share of the mortality
cost for that particular year, only. The premium then increases each year which reflects
the increase in mortality (more persons dying) each year as the individual gets older.
Mortality tables are derived from company’s experiences for certain periods of time.
One table in common use is the 1980 Commissioners Standard Ordinary (CSO)
Mortality Table. It is used by regulatory bodies for determining the reserves that must
be posted by the insurance companies and regulators require very conservative
8
assumptions, particularly when it comes to establishing reserves – as their primary
function is to make sure that insurance companies have sufficient funds on hand to pay
claims. While mortality has improved considerably since 1980, this mortality table is
still used in some situations. The following chart shows the rates of mortality per 1,000
lives:
AGE
10
20
30
40
50
60
70
80
90
99
MALE
0.73
1.90
1.73
3.02
6.71
16.08
36.51
98.84
221.77
1,000.00
FEMALE
0.68
1.05
1.38
2.42
4.96
9.47
22.11
65.99
190.75
1,000.00
This table shows that the chances of dying increase with age, and it also shows that
female mortality is better than male mortality – which incidentally shows up in all
mortality tables, including foreign tables. Therefore, males pay higher premiums for
life insurance (females pay higher premiums for annuities for the same reason).
As an example, the mortality rates for females age 30 is 1.38 per 1,000 lives.
Therefore, if 100,000 females age 30 are insured for $1,000 each, the insurance
company would pay 138 death claims for a total of $138,000. If 100,000 persons were
insured, the company would have to collect $1.38 from each insured to meet the 138
death claims. This is the death rate and it ignores investment income and loadings.
If the insurer assumes a 5% investment return on all funds invested, and since premiums
are paid at the beginning of the policy year (which is typical), and then use the
(unrealistic) assumption that all death claims are paid at the end of the year (for
simplicity and illustrative purposes), the insurer would then have the funds for an entire
year for investment.
The insurer does not have to collect the entire $138,000, but only has to collect
$131,430 ($131,430 x 1.05 = $138,000 [$1.50 left over]), or collect $1.31 from each
insured.
To this would be added expenses (loading) and simply put, the loading expenses would
be distributed among the 100,000 lives and added to the total premium, then split
among the policyowners.
This is simple, but it should be taken one step further to explain the process of
determining premiums for a level premium policy. In the situation above, the pre mium
will have to increase each year, and where the mortality rate goes up, premiums
9
increase. Then what inevitably happens? Obviously there will be some insureds drop
out as the premiums become too expensive, particularly the healthy ones. This means
that the ones who are not as healthy (or as old) will remain, as they are more likely to
incur a claim. This is known as adverse selection (discussed later in more detail) and it
means that those who are more likely to receive benefits will stay, and the b etter risks
will leave. Because of this, insurers are likely to limit the period in which an YRT
policy can be renewed, or will adopt much higher premium levels at the older ages to
compensate for the adverse selection.
For single-premium life insurance plans, a modified CSO mortality table
(Commissioners Standard Ordinary) approved by the NAIC and used in calculating
minimum non-forfeiture values and policy reserves for ordinary life insurance policies.
It depicts the number of people dying each year out of the original population, not as
individuals, but in age groups. The formula to obtain those premiums uses the number
living at the first of the year (such as 100,000 in the previous illustration) decreased by
increments as the population of the tables age.
Actually, a life insurance policy can be seen as a series of YRT insurance policies
continuing to the end of the mortality table. With single premium plans, the premiums
are all paid in advance for the life of the policy, so the excess funds wil l have to be
invested and then credited properly throughout the life of the contract.
Few persons purchase life insurance on a single premium basis because of the up -front
premium. Also, because of the ever-increasing premiums for an YRT policy, few
people are interested in purchasing YRT insurance, except for special situations where
short term insurance is needed. These problems are solved through the use of a level premium plan.
Level premium plans were devised so that the company can accept the same premium
each year if the premiums collected are the mathematical equivalent of the
corresponding single premium. As is obvious, the premiums collected in the early years
will be more than necessary to pay for death claims, and the premiums in the lat er years
will not be sufficient to pay death claims. It has sometimes been said that life insurance
was the first product that was sold on an installment plan.
The premium is level because of this overpayment of premium in the early years. At
any time, the fund, future interest and future premiums, all together, should be
mathematically able to pay all death claims as they occur during the time that the
coverage continues.
A “whole life” policy can have premiums paid over the entire policy duration – this
policy is also known as ordinary life insurance. Whole life policies can have level
premiums that can be paid over a shorter period, such as 10 or 20 years, or for a
specified period, such as age 65.
10
RESERVE CALCULATION
There is one other important calculation that must be discussed, that of policy reserves.
Reserves will be considered in more detail later in this text, but at this point the
“Prospective” Reserve definition is applicable.
A Prospective Reserve is the amount designated as a future liability for life (or
health) insurance to meet the difference between future benefits and future premiums.
In determining this reserve, the Net Level Premium is determined so that this basic
relationship holds: The present value of a future premium equals the present value of a
future benefit (which is a simpler way of expressing the Prospective Reserve). This
relationship, incidentally, exists in fact only at the point of issuance of a life insurance
policy. After that, the value of future premiums is less than the value of future benefits
because fewer premiums are left to be paid. Thus, a reserve must be maintained at all
times to make up this difference.
The actual amount of life insurance protection (before loading) at any point in the
policy term is the difference between the policy reserve at that point, and the face
amount. This is called the net amount at risk.
When looked at in this aspect, it is simply dividing a life insurance into two sections –
an increasing reserve and a decreasing net amount at risk.
FLEXIBLE PREMIUM PLANS
Many insurers sell policies that have flexible premiums; i.e. the policyowner determines
the amount of premium that they would like to pay. This is the case with Universal Life
(UL), Variable Universal Life, etc. Unlike other policies, the cash values of a
Universal Life policy are a function of the premium payments that have been made in
11
the past, and in the present. The UL type of products have cash values that are
determined differently than the calculation of the Net Amount at Risk, as shown above
where the Net Amount at Risk and the Reserve always equal the face amount of the
policy. Rather, the cash values of the UL products are determined by the way the
policy is structured.
The policyowner may pay whatever premium they wish (subject to company rules). An
amount, which is equal to the insurer’s loading and expenses, and mortality charge, is
subtracted from the cash value. Thereafter, the amount remaining in the cash value,
plus any premium payment made and the previous period’s fund balance equals the cash
value for the next period. The mortality charges are based on the policy’s net amount at
risk, but using a cash value instead of the reserve. Any interest earnings on the cash
value are credited to the cash value, usually on a monthly basis. In addition, there
usually is a surrender charge if the policy is terminated early.
This is a highly flexible plan (as discussed later) so there can be no illustration to show
how the premium develops, as the insured develops the premium payment schedule as
they wish.
T H E S A V I N GS E L E ME N T I N L I FE I N S U R A N C E
Many life insurance policies have cash values and all cash values stem from the same
cause; the excess premium charged in the early years in order to maintain a level
premium. However, cash value is viewed by the general public as simply a by -product
of the level premium payment-of-premium method. This was the view held for many
years, until the advent of interest-sensitive insurance products, in particular Universal
Life. In these cases, the cash value is looked upon as a separate and independent part of
the policy, from which funds are withdrawn to pay for mortality and loading charges.
Some have considered a permanent type of level premium policy as simply a liability
held by the insurance company to pay any future claims – the reserves – plus term
insurance. To some this is witnessed by the ability to withdraw all of the cash value,
and the policyowner can borrow part of the cash values as a loan . Regardless of the
appearance of two contracts – death benefit and cash value – it is important to
understand that it is still only one policy. This is evidenced by the fact that a
policyowner cannot withdraw all of the cash value without also giving up all of the
death protection. Legally, and actuarially, a life insurance policy is an indivisible
contract. Unfortunately, some companies and individuals continue to present
permanent life insurance as a combination of decreasing term and increasing savi ngs.
Not too many years ago, there have been financial fortunes built on the concept of “buy
term, and invest the difference.”
Universal Life will be discussed in more detail later, however at this point it is
important to recognize that Universal Life (UL) and other “interest-sensitive” products
12
are different from other insurance products inasmuch as they are extremely flexible and
they are “transparent.”
UL type policies are flexible as the policyowner may increase or decrease the premium
(even eliminate the premium, in some cases), and they may also increase or decrease the
policy face amount within certain guidelines.
UL type policies are “transparent” inasmuch as the main ingredients of life insurance
policy premiums – mortality, interest and expense/loading – are identified to the
purchaser, individually and collectively. As stated earlier, the savings part of the policy
is directly related to the amount of premium paid by the policyowner. Generally, the
higher the cash value, the higher the premium. Therefore the mortality protection
portion of the policy and the savings element are divisible, and they are “transparent”,
as the methods used to determine these aspects are apparent to the policyowner.
Like a couple looking at a Corvette and a Minivan – they are both transportation but
they serve different purposes. So whether a policy can be divided or is indivisible is
simply different ways of looking at the same thing.
PO L I C I E S T H A T PA R T I C I PA T E I N C O M PA N Y E X P E R I E N C E – O R N O T
Life insurance policies can be segregated into those that allow for variation depending
upon the experience of the company or a particular block of business; and those that are
engraved in stone. There is also the class of policies that will provide variation
depending upon anticipated company or business results.
NON-PARTICIPATING POLICIES
Some policies provide that the premiums, benefits and cash values are “etched in
stone.” These are traditionally called “non-participating” policies as they do not
participate in any improvement in mortality or cash values, and the premiums are fixed
as long as the policy is in force. Also traditionally, these policies were sold by stock
companies as the mutual companies, which are owned by the policyowners, would
allow their policyowners/company owners to participate in better than anticipated
experience by issuing dividends. Today, stock companies may issue participating
policies and mutuals may issue non-participating policies.
Since traditional non-participating policies do not share in positive experience from
lower-than-expected mortality, higher interest earnings than anticipated, or lower
expenses &/or taxes, the policyowner has no way to participate in these favorable
results. If the policy does not reflect an increasing economy, lower taxes, etc.,
policyowners are tempted to exchange their policies for those that do participate. Of
course the healthy policyowners are the ones that would be changing, with those who
could not change policies because of health reasons, would stay with the non-
13
participating policy. Therefore, the premiums would be insufficient on the existing
block of business. Another example of adverse selection
PARTICIPATING POLICIES
Participating policies allow their policyowners the ability to share i n the increased
profits of an insurer because the actual results and experience is better than that
assumed in constructing the policy and the premium – hence the name “participating.”
Actually, these profits go toward increasing the surplus of the compan y. The company
will then declare a “distributable surplus” which will be returned to the policyowners in
the form of dividends. For example, if the company is receiving 7% on its investments,
and it had used a 5% assumption when determining premiums, the 2% difference may
be returned to the policyowner, completely or a portion thereof.
It should be noted that a “dividend” in a life insurance policy is very different from a
dividend that is declared in other industries when their profit experience is bett er than
anticipated. Premiums are usually, not always - but usually, are higher for participating
policies as they use very conservative assumptions for mortality, interest and loadings.
As a matter-of-fact, the Supreme Court has determined that a “divid end” in these cases
is simply a return of premium for tax purposes.
Agents representing mutual companies (primarily) have used policy projections when
marketing participating policies which show that the dividends more than compensate
for the higher premium, and the dividends can allow certain flexibility that non participating policies cannot. This is one reason that stock companies started issuing
participating policies) discussed later in this text).
DIVIDEND PAYMENT OPTIONS
The owner of a participating policy may choose how the dividends are paid-which
dividend payment option to choose from among those the insurer offers. Six basic
options are discussed in the following paragraphs, but many companies do not offer all
six.
Cash Dividend
Policyowners may choose to take cash dividends. Whenever the insurer pays a
dividend, the policyowner receives a check from the insurance company.
Premium Reduction
The dividends may be used to help pay the next premium. Under the premium
reduction option, the amount of the dividend is deducted from the premium so the
policyowner pays less the next time a premium is due. Since the amount of the
reduction depends upon the amount of the dividend, the normal premium is required
when no dividend is paid.
14
Paid -Up Poli cy: By using both dividends and the accrued interest on cash values, the
policyowner might be able to have a paid-up policy, i.e., both dividends and interest are
used to pay future premiums. This option requires a large policy paying large dividends
and earning significant interest. Some policies are purposely written to do just this and
the transaction is sometimes termed "vanishing premium” (discussed in detail later in
the text). A caution is in order, though, dividends are not guaranteed and if the
insurer's experience is much worse than anticipated, the policyowner might have to
keep paying premiums. In addition, the premiums required in the first years of the
policy are typically higher than policies that do not include this feature.
Paid -Up Additi ons: Alternately, dividends could be used to purchase paid -up
additions to the policy which are small additional amounts of whole life insurance
added to the existing policy without evidence of insurability and with no additional
premium required in the future for the additions. This use of dividends is essentially
the purchase of small amounts of single-premium cash value life insurance.
Accu mulation at In terest : Leaving dividends with the insurance company allows
them to accumulate at interest. The accumulated dividends and interest are then added
to the death benefit. Therefore, a $100,000 policy, in which dividends which have
accumulated at interest, and now totals $2,000, would result in death proceeds of
$102,000. While the dividends themselves are not taxable because they're considered a
return of excess premium paid by the policyowner, the interest is taxed under this
option.
One-Year Term Insurance : Dividends may also be used to purchase one-year term
insurance. The amount of term insurance that may be purchased is whatever the
dividend will buy at the insured's current age, up to the cash value of the policy. If part
of the dividend remains after the term purchase, it is usually left with the insurer to
accumulate at interest. No proof of insurability is typically required under this option.
Remember, not all of these options are available from every insurance company. In
addition, while policyowners normally select a dividend option when the policy is
issued, they usually may later switch to another option if they wish.
CURRENT ASSUMPTION POLICIES
The principal difference between “Current Assumption” policies and participating
policies is that the participating policies are adjusted according to past experience of
the insurance company, while the current assumption policies are adjusted according to
anticipated experience of the insurance company. In affect, they discount in advance
for expected favorable results.
15
STUDY QUESTIONS
Chapter 1
1.
2.
3.
4.
5.
6.
The earliest life insurance contract was written
A.
in England.
B.
by wealthy individuals.
C.
by the Insurance Company of North America created in 1794.
The “human life value” concept
A.
recognizes the value of slavery.
B.
states that the probability of loss from automobile accidents is greater than the
probability loss from death.
C.
is a method placing a value on the services of a person’s life.
A description of insurance can be reduced to three words:
A.
fire and casualty.
B.
life an health.
C.
sharing of losses.
Insurance _______________ risk.
A.
eliminates.
B.
transfers.
C.
increases.
Premiums for life insurance
A.
should reflect a different expectation of loss.
B.
must be adequate.
C.
should be lower that competitors.
The probability of losses for life insurance comes from
A.
mortality tables.
B.
morbidity tables.
C.
probability tables.
16
7.
8.
9.
10.
11.
12.
Life insurance companies
A.
charge more for younger people.
B.
require premiums be paid in advance.
C.
charge a premium calculated to cover the pure cost of probabilities only.
With a Yearly Renewable Term policy
A.
the premium remains the same each year.
B.
provides coverage for a period of one year.
C.
the policy cannot be renewed if the insured suffers bad health during a premium
period.
Level premiums
A.
means the policyowner pays less for the coverage.
B.
were devised so the insurance company can accept the same premium each
year.
C.
provide for overpayment of premium in the later years.
The cash value of a life insurance policy
A.
comes from the excess premiums charged in early years.
B.
cannot be withdrawn.
C.
means there are two policies; 1) death benefit and, 2) cash value.
The probability of loss form __________________is higher than any other commonly
insured peril.
A.
fire.
B.
death.
C.
earthquake.
Life insurance companies rely upon the effects of “the law of large numbers” to
A.
reduce the speculative element of insurance.
B.
identify specific individuals that will die in a one-year period.
C.
estimated losses during a terrorist attack.
17
13.
14.
15.
Mortality tables, are not only used by life insurance companies, but also by
A.
health insurance companies.
B.
the state department of insurance.
C.
automobile insurance companies.
All life insurance policies require premiums be
A.
fixed.
B.
excessive.
C.
paid in advance.
A “participating” life insurance policy
A.
is adjusted according to anticipate experience of the insurance company.
B.
pays dividends that are taxed as ordinary income.
C.
allows the policyowner to share in the increased profits of the insured.
Answers to Chapter One Study Questions
1A 2C 3C 4B 5B 6A 7B 8B
9B
18
10A
11B
12A
13B
14C
15C
C H A P T E R T WO - T H E I N S U R A N C E C O N T R A C T
An insurance policy is a legal contract. While it is different than most contracts that
the general public enters into on a regular basis, it is still just a contract, and as such
must meet all of the requirements of a legal contract. Basically:
 For a consideration (the premium), one party (the insurance company) agrees to pay
an agreed-upon sum of money (or to provide services set forth in the contract) if a
loss that is covered under the contract, occurs.
A life insurance “contract” can be confusing, technical and misunderstood to the
insured, so it would be easy for an insurer to take advantage of the average insured.
Conversely, the policyowners (and claimants) can take advantage of the insurer because
they can be aware of physical, moral and adverse-selection problems. The laws of
contracts as it pertains to life insurance contracts are specifically developed to eliminate
– or at least alleviate – these discrepancies that can lead to serious misunderstandings.
In the United States (and in most other countries) life insurance policy forms must be
approved by the regulating authority (usually insurance department of the state) and all
policies must contain certain “standard provisions” – which are clearly specified in the
law. The states usually do not prescribe the exact wording for these standard
provisions, but are guidelines that state that the actual wording must be at least as
favorable to the policyowner as the standard provisions.
The standard provisions generally include
 The entire-contract clause,
 The incontestable clause,
 The grace period,
 Reinstatement provisions,
 Non-forfeiture provisions,
 Policy loans,
 Annual dividends (if applicable),
 Misstatement of age,
 Settlement options, and
 Deferment of cash value and loan payments.
There are many other regulations relating to the insurance policy contract, including
identifying all policy forms by numbers, format of the first (cover) page, etc. Most
states require that the policies be written in “simplified” format, judged by its
readability and ease of understanding. The NAIC provides a model act, Life and Health
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Insurance Policy Language Simplification Model Act, for insurers to use as a guide in
this respect.
Courts have rendered decisions throughout the years that bear significantly on the way
that provisions are interpreted in life insurance policies. In addi tion, laws have a direct
impact on policy provisions, particularly Internal Revenue regulations, civil rights
legislation, etc.
CHARACTERISTICS OF LIFE INSURANCE CONTRACTS
The characteristics of life insurance policies that differentiate them from other business
contracts should be understood before discussing the contract rules of law.
An insurance contract is a contract of good faith – indeed, it is utmost good faith. This
means that both parties to the contract can rely upon the good faith of the oth er and
therefore cannot deceive or attempt to deceive, or withhold pertinent information from
the other party. Simply put, the advantages that each party has over the other, as stated
above, are not to be used against the other party. The rule of caveat emptor or let the
buyer beware does not apply in insurance contracts.
Life insurance contracts are considered as valued contracts, which simply mean that the
insurer agrees to pay a certain specified sum of money, regardless of the actual
economic loss to the insured. A life insurance policy is not a policy of indemnity as are
property and casualty and some health insurance contracts, as the amount of money that
will be paid has no relation to the actual financial loss sustained by the insured. This
can cause moral hazards to be unknowingly insured because the insureds can recover
losses for amounts greater than the economic value of lost income or attendant
expenses. Therefore, life insurers carefully consider the economic loss that an insured
could suffer in the event of the insured’s death or disability.
Life insurance contracts are contracts of adhesion. This means that the terms of the
contract are fixed by one party to the contract, and must be accepted or rejected totally
(“en totale”) by the other party. This is a very important point, as the courts look upon
a life insurance contract as highly specialized and technical, and therefore any
ambiguities in the contract will be construed in favor of the policyowner. This is why
so many life insurance contract disagreements that go to court are decided in favor of
the insured. (This is significant in all insurance policies, not just life insurance. For
instance, it applies frequently in liability and homeowner policies.)
Life insurance contracts are conditional, as the insurer’s obligation to pay claims are
conditioned upon certain acts, such as payment of the premium and proof of death.
Life insurance contracts are aleatory in nature, which means that one party can receive
more in value than the other party. Therefore there is an element of chance. (As
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opposed to a commutative contract where each party would receive something of
approximately equal value).
Life insurance contracts are unilateral in nature as the insurer is the only party that
gives a (legally enforceable) promise in the contract. The owner of the contract does
not promise to pay the premiums but if they do make the premium payments in a timely
manner, then the insurer is fully under the obligation to fulfill its obligation.
Incidentally, this can cause some adverse selection as those insureds who need the
insurance, are the ones that will make premium payments in a timely manner.
ELEMENTS OF A CONTRACT
In order for any contract to be valid, there are four requirements as pres cribed by law
that must be present:
Legally capable
The parties to the contract must be legally capable of making a contract. This means
that they must have the (legal) capacity to enter into a contract. In the eyes of the law
intoxicated persons, mental incompetents, enemy aliens, and others who are not
capable, cannot enter into a contract. A minor cannot make a contract, which is usually
the age of 18, but in certain states they can contract for necessities such as food and
clothing. In the case of an insurance policy, contracts with minors are voidable at the
option of the minor except when the minor has contracted for the necessities. In some
jurisdictions, minors as young as 15 can contract for insurance.
Mutual agreement
There must be an agreement that is based on an offer by one party and acceptance of
this offer by another party. Life insurance is different in this respect than other
contracts; for instance the insured party is usually solicited by an agent who submits the
application to the company. There are situations that arise that indicate whether the
mutual agreement is in effect.

The insurance contract is initiated by either the insured submitting an
application with a premium, or by submitting an application without the
premium. If no premium is submitted, then it is considered an “invitation” to
the insurer to make an offer, and the insurer makes an offer by issuing the
policy. The applicant then accepts this offer by paying the premium when they
receive the policy.

If the premium is paid with the application, then the applicant is considered to
have made an offer, however they can withdraw the offer at any time until the
policy is issued. Most states hold that there is no contract in force until the
policy is issued and delivered and received by the insured.

A conditional receipt may be issued, in which case there is some form of
temporary coverage given.
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The “approval conditional premium receipt” provides coverage only after
the application has been approved by the insurer. This type of receipt is
seldom used because of the short coverage period provided to the
applicant and the complaints of applicant therefore.
The “insurability conditional receipt” is most frequently used. In effect,
with this type of receipt, the insurer is considered to have made an offer.
The applicant for the insurance accepts this offer by paying the
appropriate premium. The insurance becomes effective on either the date
of the conditional receipt, or in some cases, the date of the physical
examination with the proviso that the applicant is found to meet the
insurer’s underwriting criteria. If the applicant should die before the
application and any other information required reaches the home office,
and if the applicant had met the underwriting stand ards customarily used
by the company, the policy will be considered as issued and the claim
would be paid. This type of receipt has been upheld by many courts, but
on occasion the courts have felt that the applicant had expected interim
coverage for the premiums paid, and therefore they have ruled for the
applicant.
The third type of frequently used premium receipts is the conditional
binding receipt which effectively provides insurance from the date the
insurance is written, both immediate and unconditional. Usually the
applicant must have answered all the questions on the application
satisfactorily and the coverage is provided for a stated fixed time period,
or until the insurance company makes a final underwriting determination,
whichever comes first. This type of receipt is used for temporary
insurance such as travel insurance policies and temporary health policies;
however there are a growing number of companies that use binding
receipts. One of the reasons for its popularity is that the public is used to
binding receipts in their purchase of property and casualty insurance, such
as auto and homeowners insurance where the company is “bound” upon
completion of the application.
EFFECTIVE DATE
Usually, the effective date of a policy is the date from which coverage starts, agreed
upon by both the insured and the insurer, but there can be complications.
A policy may be backdated to “save age.” Since premium is lower at a younger age,
this may be allowed if the backdating is not beyond six months – which would
otherwise be illegal in many states. This is often used for sales purposes, but it does
raise a couple of interesting questions: When is the next premium due? (and) From
what date do the incontestable and suicide periods run? Some courts have held that a
full year of coverage must be provided for the payment of a full annual premium,
although most courts have held that the effective policy date that is shown on the
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contract, is the date upon which following premiums are due, even though that mi ght
mean less than one full year of protection for the first year.
For Suicide and Incontestable clauses, which are usually for a period of two years, the
accepted rule is that the earlier of the effective date, or the policy date, is the time from
which the clause starts. With backdated policies, therefore, the suicide and
incontestable clauses could run from the policy date, but if the policy date is later than
the effective date, then the clauses run from the effective date. In some cases, a
specific date from which these clauses are to run is written into the contract, and in
those cases that date would be used.
CONSIDERATION
For an insurance policy, the consideration is the first premium payment. Legally,
subsequent premium payments are “conditions precedent” that must be performed in
order to keep the contract effective. In practice, the consideration clause is simple and
a typical clause would read:
“We have issued this policy in consideration of the representations in your
application and payment of the first term premium. A copy of your application
is attached and is part of this policy.”
CONTRACT FOR LEGAL PURPOSES
A contract cannot be used for illegal purposes, including gambling, which are contrary
to public policy. Insurance and a wager are distinctly different because the requirement
of an insurable interest in the policy removes the policy from any definition of
gambling. Besides gambling, any policy that is against public policy is illegal, such as
a life insurance policy that is negotiated with the intent to murder.
INSURABLE INTEREST
A life insurance policy must, by law, be based upon an insurable interest. Of course an
individual always has an insurable interest in his/her own life and that of immediate
family members because of blood or marriage.
Creditor-debtor relationships give rise to insurable interest. The creditor can be the
beneficiary for the amount of the outstanding loan with the face value decreasing in
proportion to the decline in the outstanding loan amount.
Some business relations can also give rise to insurable interest as an employee may
insure the life of an employer, or vice versa, as discussed later in respect to key man
insurance and other business uses of life insurance.
Insurable interest must exist at the inception of the contract, and not necessarily at the
time of the loss. For example, if a woman purchases a life insurance policy on the life
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of her fiancé, she is considered to have an insurable interest. If the relationship sours,
as long as she continues to pay the premiums, she will be able to collect the death
benefit under the policy.
CONSUMER APPLICATION
In a frequently quoted case, a child’s aunt (-in-law) named herself as applicant and
beneficiary on the purchase of three life insurance policies on her niece, with the intent
to murder the child & collect the insurance proceeds. Since the insurers did not
ascertain whether an insurable interest existed in this case, the jury awarded the father a
$100,000 wrongful-death judgement, which was substantially greater than the face
amounts on the policies. Life insurance companies nationally “sat up and took notice”
and since that time (1957) great care has been taken to make sure there is always
insurable interest.
T H E A P PL I C A T I O N
The application is considered as the applicant’s proposal to the insurance for coverage
and can be considered as the beginning of the insurance contract. Most states require
that the application become part of the insurance policy – and if the insurer does not do
so, they are estopped (prevented by law) from later denying the correctness or truth of
any information on the application. It is extremely important that the application be
completed correctly and completely, and rarely does an application with an unanswered
question or unintelligible answer will go unnoticed by various employees of the
insurance company whose job it is to review applications.
CONCEALMENT, MISREPRESENTATION, FRAUD
Concealment is the withholding of information of facts that the insurance company
should know. As stated earlier, a life insurance contract is a contract of utmost good
faith, and the insurance policy depends upon full disclosure of all material information.
Whether a fact is material depends upon whether the insurer would have acted as it did
by issuing the policy and at the premiums it charged, if they had known the actual facts.
Therefore, the general rule about materiality is if the facts had been presented
accurately and truthfully to the insurer, would the insurer have denied th e application,
charged a higher premium, or issued a policy with limited benefits.
The doctrine of warranty requires that the statement be absolutely and literally true.
However, since it caused hardship to some insureds as the insurer could void a polic y if
the statement were only technically true, regulations were passed that state, in effect
(the wording varies widely), that statements made by the insured were representations,
and not warranties. Therefore, the doctrine of warranty is not effective to day.
A representation is a statement given to an insurance company concerning personal
health history, family health history, occupation and hobbies. These statements are
required to be substantially correct; that is, applicants must answer questions to the best
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of their ability. In most cases, representations are construed by the courts very liberally
and they need to be only substantially correct.
A misrepresentation is when a statement given is incorrect. In most states, a materially
false representation makes an insurance policy voidable at the option of the insurance
company. Fraudulent intent need not be proven in most jurisdictions. In other
jurisdictions, fraudulent intent can automatically make the policy voidable, therefore
the definition of intent is important and varies by jurisdiction.
An individual who intentionally misrepresents or conceals a material fact, intending to
deceive the insurance company in order to gain the benefit of the policy, is guilty of
fraud. To be guilty of fraud, there must be intentional misrepresentation or
concealment of a material fact, and there must be an intent to deceive in order to
receive the benefit.
PRESUMPTION OF DEATH
A discussion of the contractual application of a life insurance policy would not be
complete without a mention of the presumption of death. Because of television and the
movies, most people feel that they are at least aware of these laws.
The terminology of the life insurance contract states that there must be due proof of the
death of the insured before benefits can be paid. This can be particularly difficult if the
insured has disappeared and there is no trace of where they are. The basic law is that if
a person leaves their place of residence and is neither heard from or seen, o r known to
be living, after a period of seven years, the person is presumed to be dead. If an insured
disappears for 7 years and the absence is unexplained, then the benefits will be paid.
Court cases involving presumption of death usually revolve around whether the absence
can be explained.
In order to prove that the absence cannot be explained, the beneficiary (who is usually
the plaintiff in these cases) attempts to prove that the insured was happy and had no
financial problems, and therefore there was no reason for the insured to disappear. The
burden of proof falls on the insurer to disprove these facts, and they may attempt to
show that the insured was unhappy, financially insolvent, or had a girlfriend not known
to his wife (for instance).
The remaining question is: when did the insured die? A few jurisdictions hold that the
insured died on the last day of the 7-day period. However, if it can be shown that there
was some peril involved (tornado, hurricane, etc.) then the court would generally rule
that the date of death was the date of the peril, in which case the death benefit plus
interest from that date would be paid.
What happens when the insured has been gone for more than 7 years and the death
benefits have been paid to the beneficiary and the insured shows up again? If the
benefits were paid in good faith, the insurance company has the right to recover on the
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basis that it was simply a mistake in fact. Interestingly, however, if the insurance
company did not pay the full death benefit, such as under a settlement agreement
(which is quite common in these cases), then the insurance company has no recourse
and the beneficiary gets to keep the settlement money that had already been paid.
INCONTESTABLE CLAUSE
The pertinent policy provision simply states that (except for accidental death and
disability premium payment benefits), the insurer cannot contest the policy after it has
been in force for two years while the insured is still alive.
This clause stems from an old English provision, the “indisputable clause” which was
used to counteract the very tough warranty provisions in the policies at that time. This
clause was more for public perception in the beginning in the U.S., shortly after the
Civil War, but became an “institution” when adopted by the Equitable Life Assurance
Society in 1879. Its purpose is to remove the worry to the insured and the
beneficiary(s) that the life insurance company may not pay. Even if the insured had
misrepresented a material fact at time of application, a fter two years the insured may
not be around to contest such accusations of the insurer. It limits the time that the
insurance company can use the defense of fraud, concealment or material
misrepresentation in order to keep from paying benefits.
SUICIDE CLAUSE
Suicide is covered in the same fashion. It is felt that if a person purchases life
insurance in anticipation of suicide, they will commit suicide (usually) within two
years, or never at all – and this has held true in most cases. Insurers have always had a
difficult time in denying claims because the insured committed suicide, even within two
years.
CONSUMER APPLICATION
About 30 years ago, in Colorado, an insured that, within weeks of the purchase of life
insurance, discovered that his wife was sleeping with his brother, went for a walk in a
pasture in fresh snow (his were the only tracks). He carried a single-shot, bolt-action
22 caliber rifle. He was found by his brother later in the day with TWO bullet holes in
him, one in the chest (obviously the first, which did not kill him) and the second was
through the top of his head – coincidentally he had the rifle barrel in his mouth. The
court ruled that it was accidental. (An actual case, from files of a Colorado insurer)
The typical suicide clause states that the insurer will not pay if the insured commits
suicide (while sane or insane) for the first two full years from the original application
date. For suicide, they will void the policy and return the premium (less any loans).
Also, note the “sane or insane” wording. In practice, some courts have consistently
held that an insane person cannot commit suicide because a person must know right
from wrong in order to commit suicide, even though the suicide provision included this
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“sane or insane” wording and the policy form was approved by the state insurance
department.
Courts will often seek ways of ruling so that dependents can collect benefits. For many
years it was widely reported that in the state of Louisiana, which has a very large
Catholic population, no life insurance company had ever won a “suicide” case in that
state. Catholics believe suicide is a sin and if a Catholic committed suicide, they could
not be laid to rest in consecrated ground – causing great suffering to the remaining
family members.
GRACE PERIOD
The Grace Period provision requires the insurance company to accept premium
payments for a certain number of days – typically 31 days for life and health policies
and 60 (or 61) days for flexible-premium contracts. The insurance company is
obligated to accept the premium payment even if it past the due date and they may not
require evidence of insurability as a condition to accepting the premium.
If the insured dies during the Grace Period, the premium due and interest on the
premium due may be withheld from the benefit payment. This provision is for the
protection of the policyowner and protects them against unintentional lapse. In some
ways, this is treated as “free” insurance as if the policy lapses; the insured is covered
for the Grace Period with no additional premium, because if they should die during the
Grace Period, benefits would be paid (less due premium).
DELAY PROVISION
In U.S. life insurance policies only, all policies must contain the Delay Provision. This
allows the company the right to defer any cash-value payment or making a policy loan,
for a period of up to 6 months after it has been requested. This does not apply to death
claims.
The purpose of this little-known provision is to protect the insurance company from
mass policyowner action draining assets from the company – similar to the runs on the
banks during the depression. Mass withdrawals from banks, securities firms and
insurers and reinsurers could cause disruptions in the life insurance in dustry,
particularly in today’s business atmosphere where there are close affiliations between
securities firms and insurers.
The delay provision allows time for the insurer to investigate questionable situations
and to make financial arrangements if necessary, and further, it provides a cushion from
some external event affecting the financial stability of the company.
A “run” on an insurer, where policyowners and creditors demand their money all at
once, has occurred in the recent past. The two largest U.S. life insurance company
failures, Executive Life and Mutual Benefit Life, initiated runs. There have been other
27
runs on smaller insurers. As of this date, these types of runs have been limited to
insurers already in financial difficulties, but with the relationship with non-insurance
financial institutions, this may change.
EXCLUSIONS
The two types of exclusions generally used are the war exclusion and the aviation
exclusion. Underwriting these risks is considered in the Underwriting section of this
text.
AVIATION
Occasionally, aviation exclusion is added to a policy by the underwriting department,
usually in those cases where the pilot is flying experimental or military craft or is not
experienced. This is not usually added, as even commercial pilots who fly a lot, can
qualify for standard insurance. Usually the insured has the option of paying a higher
premium instead of the exclusion.
WAR EXCLUSION
This exclusion is of interest at this time, so soon after the terrorists attacks (Sept.
2001). This is also described in the Underwriting section of this text from the
underwriter’s viewpoint.
There are two types of War Exclusions, status type and the results type.
Under the status clause the insurance company has the right not to pay the death claim
if death results while the insured is in the military, regardless of cause of death. Some
insurers exercise this right only if the insured is outside of the “home area,” i.e., outside
the United States.
The other type, the results clause, the insurer can refuse to pay the death claim only if
the death is a result of war activity.
There has been a considerable amount of litigation regarding whether a policy provision
is of the status or results type, and also what constitutes a war. If the war ag ainst the
terrorists continue and there are casualties, it will be interesting to see what stand will
be taken by the insurers, especially if there is the anticipated covert action. A lot of
litigation can be expected, although it is expected that insurer s will stretch definitions
on behalf of the insureds when possible in this situation.
BENEFICIARY PROVISION
The beneficiary clause in a life insurance policy allows the policyowner to determine
who will receive the insurance amount in case of death of the policyowner. Within the
guidelines of insurable interest, the policyowner can name just about anyone they
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choose as the beneficiary. As a side note, in the United Kingdom there is no
beneficiary clause, all proceeds are distributed according to the dece dent’s Will.
BENEFICIARY DESIGNATIONS
PRIMARY BENEFICIARY
The person who is named first to receive the proceeds, is called the primary beneficiary
and there can be more than one primary – first named does not mean first on the list or
first alphabetically, only that the proceeds are paid first to the primary(s).
The time between naming the primary beneficiary and the time that the insured dies can
stretch into several years and the beneficiary may precede the insured in death. If there
were no other beneficiaries named, then the proceeds would go into the estate – not a
good situation, as there would be added costs. (See below)
CONTINGENT BENEFICIARY
The solution to the problem of not having a named beneficiary, is by naming a
contingent (or secondary) beneficiary. This simply states that in case the primary
beneficiary is not alive to receive the death proceeds of the insured, the proceeds would
then go to the person(s) named as contingent beneficiary(s). There can also be more
than one contingent beneficiary, and they can be named to receive benefits under a
settlement option.
Legally, the contingent beneficiary is a tertiary (later) beneficiary and is usually named
at the same time that the primary beneficiary is named. Frequently the relationshi p
between the insured and the contingent (and the primary) beneficiary is identified, such
as “All proceeds under this policy shall be paid to Anna Jean Smith, wife of the named
insured, if living; otherwise the proceeds shall be paid to Jack J. Brown, nep hew of the
insured.”
REVOCABLE BENEFICIARY DESIGNATION
A revocable beneficiary designation is a beneficiary designation that allows the
policyowner to change beneficiaries at any time without knowledge of or permission of,
the beneficiary. This is rather typical, particularly in policies of smaller amounts.
With a revocable beneficiary designation, the policyowner is the only one who has an
interest in the policy and the beneficiary has no position, other than to expect that the
proceeds will be paid to them upon the death of the policyowner.
IRREVOCABLE BENEFICIARY DESIGNATION
An irrevocable designation cannot be changed without the permission of the
beneficiary. This gives the beneficiary significant rights to the policy proceeds, and
neither the policyowner nor creditors of the policyowner can change the proceeds
distribution without the explicit and written approval of the beneficiary.
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This is almost the same as joint ownership, except that many policies specify that only
the policyowner can withdraw cash values, make policy loans, or take other actions of
this type.
NAMING THE BENEFICIARY
A person can name children as beneficiaries. Rather than naming each child
individually, parents may name children as a class; for example: "Shared equally amon g
all children born from the marriage of the insured to J. B. Ashe, including adopted
children." In this case, the class designation ensures that any children born after the
policy is issued will benefit. The class designation also avoids confusion if a child dies
before the insured and the insured fails to change the designation.
It is not necessary to name only children as a class, for instance all “siblings” can be
named, and quite commonly, “All grandchildren of the insured.”
Sometimes insureds name their estates as the beneficiary. This is the least favorable
type of beneficiary designation because if the policy proceeds go into the estate, they
increase the size of the estate, which could in turn increase estate taxes that become due
when the insured dies. In addition, if the insured failed to leave a will, the executor of
the estate would have no way of knowing how the insured really wanted the policy
proceeds distributed. Even if a will existed, indicating how to distribute proceeds,
probate court actions can take months to complete. Life insurance proceeds that go into
an estate are also more vulnerable to attachment from the deceased person's creditors.
When two or more individuals are named as primary or contingency beneficiaries, one
or more might die before the insured, raising questions about how the policy proceeds
should be divided among the living beneficiaries. There are two different methods of
beneficiary designation that can be used to alleviate this situation.
PER CAPITA
A per capita designation is used to indicate that any remaining beneficiaries share
all of the proceeds equally. The legal term per capita, derived from Latin, literally
means "by heads" and is translated to refer to "each person." For example, suppose
the insured names his four sisters to share equally as primary beneficiaries of his
$100,000 policy. If all four are living when the insured dies, each person receives
$25,000. But suppose two of the sisters die before the insured. When the insured
dies, each person still living receives $50,000-the two remaining sisters in this
example.
PER STIRPES
A different arrangement applies under a per stirpes designation. Per stirpes,
literally, "by branches," legally refers to a progression through the branch of a
particular family member. For the situation described in the preceding paragraph,
the following would transpire with a per stirpes designation. The two living sisters
would receive $25,000 each as originally planned. But the remaining two shares of
$25,000 each would pass on to the heirs of each of the deceased sisters, to each
30
sister's "branch" of the family, so to speak, rather than being divided between the
two living sisters.
MINORS, TRUSTS AND ESTATES
As a general rule, children are not recognized as compet ent to handle financial
transactions. If an insured insists on naming minors, the insurer might require that a
trust be established to hold the policy proceeds until the minors are adults. Alternately,
the insurer could arrange to hold the proceeds, pay i nterest, and disburse the proceeds
plus interest when the minors reach adulthood.
Spendthrift Clause or Spendthrift Trust
A spendthrift clause included in some life insurance policies is intended to protect
policy proceeds from creditors by establishing a trust to receive the death benefit.
Under this arrangement, the policy proceeds are paid out as periodic income rather than
in a lump sum. The payout could be arranged as a fixed payment for as long as the
money lasts or for a fixed period of time. The proceeds are then usually protected from
creditors until the terms of the trust have been fulfilled. While this is the intent, the
extent of the protection varies from state to state.
While some state laws protect the entire death benefit as long as it is paid in
installments, others allow only a portion of each fixed payment to the beneficiary to be
protected by a spendthrift trust. For example, the law might require that if the
beneficiary receives more than "X" number of dollars per month under the trus t,
creditors may pursue any additional amounts. In still other states, the income is
protected only while it is in the insurer's possession; after a payment is made to the
beneficiary, the money is no longer protected.
Uniform Simultaneous Death Act
The unhappy possibility of family members dying at the same time or nearly at the same
time can cause complications in beneficiary designations. Since it is fairly common for
a spouse and/or children to be named as beneficiaries, what happens, for example, if the
insured and her husband, the primary beneficiary, are killed in the same accident?
CONSUMER APPLICATION
Angela is the insured under a whole life insurance policy. Her husband Dominic is the
primary beneficiary. The couple has no children. Angel a's sister Stephanie is the
contingent beneficiary. Angela and Dominic are involved in an automobile accident;
both are pronounced dead upon arrival at a nearby hospital. The question arises: Did
Angela die first, making the policy proceeds payable to Dom inic, or did Dominic die
first, making the proceeds from Angela's policy payable to Stephanie?
If Dominic lived longer than Angela, the policy proceeds would be paid into his estate
and distributed according to his will. If Dominic as the primary benefici ary, died
before Angela, Stephanie would receive the proceeds as the contingent beneficiary.
Recognizing the problem, most states have adopted the Uniform Simultaneous Death
Act, which assumes that the primary beneficiary died before the insured. As a res ult,
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the policy proceeds are paid to the contingent beneficiary. This is true only when there
is no evidence that the primary beneficiary did, in fact, outlive the insured. Using the
above Consumer Application, if the emergency personnel who accompanied Dominic in
the ambulance attested that he had vital signs up to the time they arrived at the hospital.
Conversely, no one in the ambulance with Angela believed she was alive during the trip
to the hospital. In this case, there is evidence that Dominic did outlive Angela, so the
policy proceeds would be paid into his estate rather than going to the contingent
beneficiary, Stephanie.
Common Disaster Provision
Another way to mitigate the problem is by including a common disaster provision in the
beneficiary designation. A typical provision would stipulate that in situations where
there is serious injury to both the insured and the primary beneficiary in a single event,
the policy proceeds are held in trust for a specified period of time, often from one to
three months. If the primary beneficiary is alive after the specified period expires, the
primary beneficiary receives the death benefit. Otherwise, proceeds go to the
contingent beneficiary. This provision might also be called a survival clause or simil ar
term.
Still another option is to arrange the policy so proceeds are paid as periodic income to
the primary beneficiary as long as he or she lives. Upon the primary beneficiary's death,
the remaining policy proceeds are paid to the contingent beneficiar y. Insurers will work
closely with insureds to see that the designation is worded to provide protection for the
beneficiaries as precisely as the insured desires.
NON-FORFEITURE PROVISION
The non-forfeiture provision is applicable only to life insurance policies with cash
values (although there are other types of insurance that may have this provision, such as
some Long Term Care Insurance policies). This provision outlines the options that are
available for the insured to collect the cash value if the p olicy is terminated. It also
explains the method that is used to determine these options.
“Non-forfeiture” gets its name, as, historically, early insurance policies had no cash
values, so any excess premium paid after mortality and expense charges were d educted,
was “forfeited.” This is not allowed in the United States and insurers must comply with
the Standard Non-forfeiture Laws that also require the policy to state what mortality
table is used and the interest rate in calculating the non-forfeiture values. A table in
each cash-value policy is required which shows the cash surrender values and other
non-forfeiture options for the first 20 years. (Non-forfeiture options are discussed later
in the text)
These laws set forth the situations under which a life insurance policy must have nonforfeiture values and they also stipulate the minimum required values and effectively,
require that all policies that collect more than mortality and expense charges, provide
non-forfeiture values. It should also be pointed out that the stated interest rate for non-
32
forfeiture values is not the “rate of return” of the policy. Universal Life and Current
Assumption Life policies are different, as cash values are derived using the so -called
retrospective approach.
The differences between the prospective method of determining cash values for
traditional policies, and the retrospective method used for UL and Current Assumption
products, is quite technical and beyond the scope of this text. It is mentioned here as a
note of interest. When actuaries were trying to develop an insurance policy wherein the
cash value accumulation could compete with other non -insurance products, the Standard
Non-forfeiture Laws would always prove to be a major stumbling block. Finally, at an
international reinsurance meeting in Monte Carlo, through the genius of American
actuaries and a German actuary meeting privately, this retrospective method was
developed, and the Universal Life insurance policy was “invented.”
NON-FORFEITURE OPTIONS
Since the cash value in the policy belongs to the policyowner, they will not be forfeited
even if the policyowner is not able to pay the premiums. Therefore, the policy offers
options as to how the policyowner can receive the cash values.
CASH SURRENDER
The policyowner may receive the cash surrender value of the policy. This involves
withdrawing the entire cash value and surrendering or terminating the policy. The
insurance company deducts any outstanding loans, interest on loans and unpaid
premium before paying the cash value to the policyowner.
Cash value policies include tables showing the cash surrender value for every year the
policy is in force which is the basis for the amount due the policyowner. However,
Universal life policies have only a minimum cash value guarantee and a variable policy
has no guarantee at all. These policies might include an illustration of potential cash
values based upon assumed rates, but, unlike the tables in traditional policies, there is
no guarantee that those potential values will be available at any given time.
PAID-UP INSURANCE
Another non-forfeiture option is to use the cash value to buy paid-up insurance. This
provides a reduced amount cash value life insurance for which the policyowner never
pays another premium. The paid-up policy is the same type of insurance as the basic
policy from which the cash value is being used. No riders or other provisions added to
the original policy are included. Cash values accumulate in the paid -up policy and the
policy earns interest. If the original was a participating policy, the paid -up policy will
also earn dividends.
The amount of the death benefit for the paid-up policy depends upon how much
coverage the cash value will buy. Any outstanding loans and interest are deducted first
and the insured’s attained age is used to determine the cost. Administrative expenses
will be small because it costs insurers very little to provide a paid -up policy from cash
values.
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EXTENDED TERM INSURANCE
The policyowner may use cash values to purchase extended term insurance. In this
case, the death benefit is the same as the original policy (unless a loan is outstanding)
and the "extended term" is the number of years and days of coverage that can be
purchased with the available cash value at the insured's attained age. Policies that have
guaranteed cash values include a table showing how long the term will be, based upon
these factors.
If there is an unpaid policy loan, the insurance company deducts the amount of the loan
and any interest due from both the cash value and the death benefit amount before
determining the length of the extended term. For example, if the original policy has a
$100,000 death benefit, a cash value of $20,000 and an outstanding loan with interest of
$5,575, then the death benefit of the extended term policy will be $94,425 and the cash
value used to purchase the policy will be $14,425.
The outstanding amounts are deducted from both the cash value and the death benefit to
protect the insurance company. If the insured should die soon after opting for the
extended term insurance and before repaying the policy loan, the insurer would have
lost the loan amount completely since there is no longer any cash value as collateral. If
a policyowner simply stops paying premiums and does not choose a non-forfeiture
option, insurers automatically set up the extended term insurance unless the policy also
includes the automatic premium loan provision described earlier. This non-forfeiture
option provides the most insurance protection for the cash value available.
STUDY QUESTIONS
Chapter 2
1.
2.
A life insurance policy
A.
is not a contract because it is regulated by the department of insurance.
B.
is not subject to judicial review.
C.
forms must be approved by the state department of insurance.
The rule “caveat emptor“ or “let the buyer beware”
A.
does not apply in insurance contracts.
B.
means the party to an insurance contract can trust the other party.
C.
applies to all contracts, including life insurance contracts.
34
3.
4.
5.
6.
7.
8.
A life insurance contract is conditional
A.
on the insurance company’s ability to pay a claim.
B.
on the payment of premiums by the insured.
C.
upon the insured answering questions on the application truefully.
The incontestable clause in a life insurance contract
A.
allows the insurance company the right to refuse paying a claim due to the suicide
of the insured.
B.
limits the time an insurance company can refuse to pay a claim.
C.
prevents the insurance company from denying a claim even if the insured stops
paying the premiums.
An insurable interest
A.
must exist at the inception of the contract.
B.
does not exist in an employment relationship.
C.
a husband may have in the life of his wife ends when they divorce.
The application for a life insurance policy
A.
is the insurance company’s offer to insure an individual.
B.
becomes part of the insurance policy.
C.
is a formality and of no consequences.
An insurance company
A.
does not have to accept a premium if it is late.
B.
will not pay a claim if the insured dies within the grace period and the premium
was not paid.
C.
is required to accept the premium payment, even if it’s past due, within 31 days.
The primary beneficiary
A.
can not be changed without the consent of the beneficiary.
B.
is the same as the contingent beneficiary.
C.
is the person who is named first to receive the death proceeds.
35
9.
10.
11.
12.
13.
14.
If a life insurance policyowner names his/her estate as beneficiary the
A.
size of the estate increases.
B.
proceeds avoid probate.
C.
insured’s creditor cannot get to the proceeds.
Per Capita is a beneficiary designation that
A.
refers to a progression through the branch of a particular family member.
B.
is used to indicate that any remaining beneficiaries share all of the proceeds
equally.
C.
means the beneficiary can borrow against the policy.
Life insurance contracts are considered as “valued” contracts which means
A.
it is an indemnity contract.
B.
one party can receive more in value than the other party.
C.
the insurance agrees to pay a certain sum of money, regardless of the actual
economic loss to the insured.
A life insurance contract
A.
requires the parties to be legally capable of making a contract.
B.
can be amended and changed by the insured.
C.
is “unilateral“ in nature, which means the owner must pay (legally enforceable)
the premiums.
Usually the effective date of a life insurance policy is
A.
the date the insured died.
B.
when the application is signed.
C.
the date from which coverage starts.
Statements made by an applicant are considered
A.
outside the life insurance contract.
B.
representations.
C.
warrantees.
36
15.
When a life insurance policy names an insured, that has disappeared
A.
for 10 years or more, they are presumed dead, and the insurer must pay the
beneficiary.
B.
the insurance company does not have to pay because there is no proof of death.
C.
for a period of seven years, the benefits will be paid.
Answers to Chapter Two Study Questions
1C 2A 3B 4B 5A 6B 7C 8C 9A
37
10B
11C 12A
13C
14B
15C
CHAPTER THREE – THE INSURANCE CONTRACT II
SETTLEMENT OPTIONS
The insured or the beneficiary determines how the death benefit(s) will be paid, using
a “Settlement Option.” Most companies offer all of the options presented in this
section. Even though most companies are quite liberal in allowing arrangements not
specifically mentioned in the policy, nearly all companies are more liberal at
providing settlement options while the insured is still alive. The policyowner can give
as much or as little authority in determining settlement options as they want, with the
beneficiary having no rights to change the option. Or they could set up a settlement
option arrangement that would allow the beneficiary to receive the funds in any
fashion they so desire. Insurance companies usually work with the beneficiaries to
arrive at a mutually-satisfactory arrangement.
LUMP SUM
Death benefits may be paid in one lump sum, which is how about 90% of all policy
proceeds are paid. If neither the policyowner nor the beneficiary selects a different
option, the insurer will always make a lump-sum payment of the face amount of the
policy (minus any outstanding loans, interest or unpaid premiums currently due).
INTEREST ONLY
Many policies provide for interest to be paid from date of death, even if a settlement
option has not been elected. The interest option allows flexibility as it permits
adjustments to be made because of changing economic conditions.
Owners or beneficiaries might opt to have the insurer pay interest only, at least for
some period of time, in which case the face amount of the death benefit, or the
principal, is left with the insurer to be invested and earn interest. The interest is paid
to the beneficiary periodically - monthly, quarterly, twice a year or once a year. The
policyowner may stipulate the frequency, which the beneficiary may change if they so
wish.
Many policies written with the interest only settlement option also provide that the
beneficiary may withdraw all or part of the principal amount at some point. Such a
provision can be written many ways, limiting the number of withdrawals per year for
example. Other options might limit the amount that may be withdrawn at any one time
or within a certain time period, or specifying that all may be withdrawn after a certain
length of time. A Spendthrift clause can be used to protect the beneficiary from
creditors, if specified in the policy.
Policies may also be written so the beneficiary may not withdraw any of the principal.
This brings up the question of what happens to the principal amount if the beneficiary
dies. There are two possibilities:
38
1. The principal is paid to the estate of the now deceased beneficiary.
2. The principal is paid to any contingent beneficiar y of the original insured.
The first possibility is more typical. Since the money belongs to the primary
beneficiary, now deceased, it goes into his or her estate if no alternate arrangement was
made when the beneficiaries were designated.
The second possibility occurs only if the eventuality had been pre-arranged at time of
policy issue or prior to the death of the insured. The original arrangement might have
been that the contingent beneficiary also receives interest only, rather than the principal
amount. But, unless specified otherwise, at this point the principal would be paid in a
lump sum either to the primary beneficiary's estate or to the contingent beneficiary.
FIXED AMOUNT
The fixed-amount settlement option permits the death benefit to be d istributed in more
than one payment of a fixed amount that is either originally specified by the
policyowner or selected by the beneficiary. It is in fact, an annuity certain but the
income amount is fixed, rather than the time period (Fixed -period Option, described
below). The payment might be made annually, semi annually, quarterly or monthly. For
example, the beneficiary could receive $2,500 per month for as long as the money lasts.
The portion of the death benefit not yet paid draws interest while th e insurer controls it.
Because of the interest earnings, the final payout will be greater than the original death
benefit amount. Dividend accumulations, additions payable or additional death
proceeds, combined with excess interest earned while installmen ts are being paid, will
increase the length of time the benefits will be paid, but do not affect the amount of
each installment.
The fixed-amount option has more advantages than fixed-period options because they
have more flexibility. Policyowners can vary the amount of income at different times,
and beneficiaries can withdraw all or part of the benefit; or the beneficiaries may have
the right to withdraw up to a certain sum in any one year.
FIXED PERIOD
Rather than a fixed amount, benefits might be paid for a fixed period. It is an annuity
certain over a defined period of months or years (usually not longer than 25 or 30
years). If an insured wants to be certain the beneficiary has at least some income for a
certain period of time, this is better than the fixed amount option. Interest is paid on
the retained principal. The amount of each payment depends upon the original death
benefit amount, interest earned on the decreasing principal, the length of the fixed
period and the frequency of each payment.
Most companies permit policyowners to give the beneficiary the right to receive the
present value or all remaining installment payments in one lump sum. This is called the
right to commute.
39
Any accumulations of dividends, paid-up additions, or other additional death benefit
payments, increase the income to the beneficiary but the number of installments stays
constant.
LIFE INCOME
The life income option pays the death benefit in such a way that the beneficiaries
receive an income for the rest of their lives. This option involves the purchase of an
annuity contract designed to provide lifetime income. (Annuities pay an periodic
income benefit over a specified period of time.) It is not necessary to go into the
various types of annuities, but the ones used for settlement options are immediate
annuities in most cases – this means that the amount to be distributed will be paid “up front,” in one lump sum.
The primary advantage of this option is the guaranteed lifetime income. Whether or not
that income is plentiful or even adequate, depends upon the amount of the death benefit
and the age and sex of the beneficiary, using the "rules" under which annuities are
established. For example, since women as a group live longer than men, if the
beneficiary is a woman, she will receive a smaller periodic income than a male
beneficiary.
Using annuity tables, the insurer establishes the schedule of payments. There are other
considerations as well, since a life income annuity option might be set up to benefit
more than one person. As an example, the beneficiary might be a husband and two adult
children, with the payments continuing to the children after the husband/father dies. In
this case, each individual's portion of the income would be smaller.
CASH/INSTALLMENT REFUND ANNUITY
The refund life income option may either be a cash refund option or installment refund
annuity. Both guarantee the return of an amount equal to the principal sum, less the
total payments that have already been made. As the names would indica te, the
difference is that under the cash refund option, there is one lump sum settlement made.
Under the installment refund option, payments are made in installments.
LIFE INCOME OPTION WITH PERIOD CERTAIN
This is the most popular of the options. It will pay the benefits in installments as long
as the primary beneficiary lives. If the primary beneficiary dies before a pre determined period (period certain) of time, then the installments will continue to be
paid to the contingent or secondary beneficiary, until the end of that time.
CONSUMER APPLICATION
Jennie was the primary beneficiary under Al’s life insurance policy and their
granddaughter Marie was the contingent beneficiary. Al elected the life income option
with period certain of 20 years, so that if after he died, Jennie could be taken care of
properly for 20 years, if she lives that long. If she didn’t, then Marie would have some
money to pay for college or other uses, depending upon her age at the time.(Cont.)
40
When Al died, the policy benefits allowed a monthly payment of $2500 a month for 20
years to Jennie, who lived for another 5 years. Marie would then receive $2500 a
month for 15 years.
Under this type of Settlement Option, the longer the guarantee period, the less the
monthly proceeds and the older the beneficiary, the greater the life income. The
problem with this type of option is that the amount of income that the beneficiary will
receive cannot be determined prior to the death of the insured as it depends entirely
upon the beneficiary’s age.
JOINT AND SURVIVORSHIP OPTION
Under the joint and survivorship option, the payments are paid for life as long as one of
two beneficiaries is alive (actually the beneficiaries are annuitants, as for all income
options). Depending upon how it is written, this option annuity may continue payments
in full, or some fraction thereof after the death of the first annuitant – usually 2/3 or ½
payments (joint and two-thirds, or joint and one-half).
The period certain for this type of option can be 10 t o 20 years. This is useful in
providing for a retirement income for a husband and wife. Actually, the proceeds of a
matured endowment policy (yes, there are some old ones around) or annuity, or the cash
value of any policy can be applied under this option.
OTHER OPTIONS
Some companies allow other types of options to suit a particular need.
Educational Option
This type of option provides a fixed income during the 9 or 10 months of each college
term, with the remainder provided at graduation.
Flexible Spending Account
The flexible spending account operates much like a bank account. Proceeds are paid
into an account, which draws interest, and the beneficiary can draft the account for part
or all of the funds, as they desire. Many companies use this option automatically
instead of a lump sum, as it gives the beneficiary time to determine what they want to
do with the money. Usually there is a minimum amount of $10,000 required.
Individualized Options
Insurers are very flexible in working with the insured and with the beneficiaries, so that
they all are happy. However, the insurance company will not accept any arrangement
where it has to exercise its own discretion in fulfilling the terms of the arrangement.
ASSIGNMENTS
Insurance is “property” - legally and technically - and therefore any ownership rights in
a policy can be transferred by the policyowner to another party. The term for this
tranfer is “assignment.” There has been considerable interest in assignments of policies
41
recently, principally for “viatical settlements” which has become popular because of
AIDS – some 90 percent of viatical settlements cover AIDS victims.
There are two types of assignment, absolute and collateral.
ABSOLUTE ASSIGNMENT
As the word would indicate, absolute assignment is the transfer by the policyowner of
all rights in the policy to another person. Absolute assignment is often used as a gift, as
it is a non-taxable gift and an excellent choice for personal and for tax reasons.
Ocassionally, and more so now than in previous years, a life insurance policy is sold for
a valuable consideration – usually cash. In business insurance, a policy that is owned
by a corporation (key man insurance) may be sold for an amount equal to its cash value
upon termination of employment. This is usually accomplished using an absolute
assignment.
As stated earlier, an irrevocable beneficiary must consent to an assignment of the
policy, as they are in effect, a co-owner. The question has arisen as to whether an
assignment changes the beneficiary, and the courts are split on this point. It can be a
moot point, as the new policy owner can change the beneficiary by following the
company procedures for doing so.
The most common use of an absolute assignment is viatical settlements, as describ ed
below:
VIATICAL SETTLEMENTS
The outbreak of AIDS in the United States created Viatical Settlements as the life
expectancy of an AIDS patient is relatively short, they face large medical and
hospital bills, and many are not able to work. Many of the AID S patients had (have)
life insurance policies on their own life, so in order to get money NOW, they were
(are) willing to sell these policies for a percentage of the face amount.
Individuals, insurance agents and financial planners generally bring poten tial policy
sellers to a viatical firm, which can be a specialized company or a group of
investors, willing to purchase life insurance on the terminally ill. The firm makes
an offer to the policyowner which depends on the face amount and the insured’s li fe
expectancy, taking into consideration future premium payments, outstanding policy
loans and the present interest rates. Any life insurance policy can be used, but the
firm will require certification from a physician that the individual’s condition can
reasonably be expected to result in death within a certain time period.
If both sides agree, the policy is transfered, using an absolute assignment. The firm
then names itself as beneficiary, and when the insured dies, it collects the policy
proceeds.
(Continued on next page)
42
The NAIC has enacted the Viatical Settlements Model Act in anticipation and
concern over possible abuse, which makes the viatical settlement f irm disclose to
the person who sells their policy (the viator ) certain facts on the transaction, such
as eligibility for government benefits, tax implications, the right to rescind, and
alternatives (some companies have accelerated death benefits where th e insured can
receive the present value – or close to it – of the policy benefits).
The proceeds of the viatical settlement are tax free if the viator meets the definition
of being terminally ill – the individual must be certified by a physician as having an
illness or physical condition that can reasonably be expected to result in death
within 24 months or less.
Viatical settlements are subject to the “Transfer for Value” rule for tax purposes, as
discussed later in the Taxation section of this text.
COLLATERAL ASSIGNMENT
Since insurance is property, a collateral assignment is a temporary transfer of only some
of the property – policy ownership rights – to another person and are usually used for
loans from lending institutions. The American Bankers Asso ciation Collateral
Assignment Form 10 is usually used for this purpose.
The lending institution can collect the proceeds at maturity, surrender the policy and
obtain policy loans, receive dividends, and exercise the non-forfeiture rights. The
policyowner, on the other hand, can collect any disability benefits, change the
beneficiary (but subject to the assignment) and election settlement options (again,
subject to the assignment).
The assignee (the lender usually) agrees to pay the beneficiary any pr oceeds that are in
excess of the policyowner’s debt, not to surrender or obtain a loan from the insurance
company unless there is a default in premium payments (or default on the debt), and to
forward the policy to the insurance company for any change of b eneficiary or change in
settlement options.
POLICY LOANS
COLLATERAL
The cash value of a life insurance policy serves as collateral for a policy loan in the
same way a house serves as collateral for a mortgage loan. Therefore, in order to
borrow $1,000, there must be at least that much cash value in the policy. Actually,
there must be slightly more because, typically, a 100% loan is prohibited in order to
protect the insurance company. The policyowner could borrow nearly 100% of the cash
value, but a small portion would be deducted, equal to one year's interest. For example,
if the policyowner wants to borrow the full cash value of $1,000 and the interest rate for
the loan is 8%, the insurer will keep 8% of $1,000 or $80 and lend the balance of $920.
43
As described in a later section, Variable life policies typically restrict the amount that
may be borrowed to 90% of the value of the separate account.
INTEREST
The low interest rate traditionally charged for policy loans is one of the features that
has made such loans attractive, with a 4% to 6% fixed rate being common in the past.
With the overall interest rates at the lowest in many years, it is still attractive, provided
the insurers keep their interest rates “in the ball-park” of other commercial loans. In
any event, they will probably always be much lower than credit card loans (debt) and
that would make these very attractive to many of today’s consumers. Variable interest
rates are also available, tied to a financial indicator such as the rate on U.S. Treasury
bills or Moody's long-term bond rate. When a variable rate applies, the policy specifies
when the insurer will adjust the rate, such as on the first day of each calendar quarter.
DIRECT RECOGNITION
Direct recognition is the immediate consideration of present interest rates, mortality
experience, and expenses in premiums currently charged. This is critical to the
formulation of Current Assumption Whole Life and Universal Life products.
Under the Direct Recognition principle, a policy loan can hav e a significant negative
impact on dividends paid under participating policies. When determining the dividend
to be paid on a particular policy, companies that use direct recognition take into account
the interest rate the insurer earns on the loan and th e dividend interest rate the company
has assumed it would have earned on the cash value if part of it had not been borrowed.
The difference reduces the dividend.
CONSUMER APPLICATION
A policyowner has an outstanding policy loan of $5,000, for which he is paying 7%
interest. The insurer assumes a dividend interest rate of 10%.
The dividend that is due to be paid is $500.
Since the $5,000 loaned to the policyowner is not available to earn the assumed rate of
10%, the insurer earns only the 7% interest paid by the borrower-3% less than assumed.
Three percent of $5,000 is $150, so this $150 is subtracted from the dividend paid.
Instead of receiving the full $500 dividend, this policyowner receives only $350
because of the outstanding loan.
Insurers believe direct recognition is a fairer proposition for all policyowners because it
rewards those who do not borrow money. Under this arrangement, non -borrowers
"earn" the higher dividend because all cash value is left with the insurer for earning
purposes. Borrowers receive a smaller dividend because not all of their cash value is
available to the insurer to earn interest.
44
INTEREST PAID ON BORROWED VALUES
As detailed later in this text, for universal and variable life policies, insurers might pay
a lower interest rate on the borrowed portion of cash value that is serving as collateral
for a loan. That is, the typically higher current interest rate is paid on cash values that
are not collateral and a lower rate, often the guaranteed rate, is paid on the portion
borrowed. Additionally, universal life policy loans might be "wash loans" with the
interest charged on the loan canceling out the interest paid on the cash value that serves
as collateral.
Policies other than universal and variable life also have arrangeme nts for paying a
lower rate on loaned cash values. Some companies, for example, pay 1 % less on the
loaned values than on the remainder of the cash value.
LOAN REPAYMENT
Because borrowing cash values represents a loan, repayment is expected, even though
the loan need never be repaid. The policyowner may continue paying interest on the
loan indefinitely. The negative consequences for not repaying loans from cash values
include:
 Reduction of the death benefit by the amount of the loan and any interest due if the
insured dies with the loan outstanding.
 Reduction of the surrender value if the policyowner wants to terminate the policy
and take the entire cash value.
 Effect on dividend payments in par policies, described previously.
 Reduction of interest earned, described previously.
 Potential depletion of values, (causing:)
 Lapse of universal or variable policies.
If a policy is about to lapse because of outstanding loans and/or interest due, the
insurance company must notify the policyowner in time to repay th e loan or make
premium payments to keep the policy in force.
REINSTATEMENT CLAUSE
The reinstatement clause allows the policyowner to reinstate a policy that had lapsed,
under certain requirements. The most important requirement is to furnish evidence of
insurability and pay past-due premiums.
“Evidence of Insurability” is required by the company to prevent adverse selection.
Otherwise, it would be common for an individual to allow a policy to lapse, and then
discover that it would be for their benefit to keep the policy in force (they have just
been diagnosed with a fatal disease, for example). The insured is required to furnish
evidence of insurability that is satisfactory to the company. While good health is the
usual requirement, the company may also require information on the travels of the
insured, occupation, financial condition, etc. An example frequently used is of an
45
insured that is in prison and sentenced to the gas chamber. He might be in good health
now…
What is interesting about this provision is its relationship to the incontestable clause. If
a policy is reinstated, what happens? Does the incontestable period start all over again?
While laws are really not very clear on this matter, the general practice is that the
incontestable clause is also reinstated, making the policy contestable again but only to
statements made in the reinstatement application. While other jurisdictions state that
the original incontestable clause is still in effect (period dated from policy date), there
are a few jurisdictions that take the view that the reinstatement (itself) is a separate
contract that has no incontestable period. Fair? Hardly, because this also means that
the policy can be contested for fraud at any time.
For the Suicide Clause, courts have been almost unanimous in holding that the suicide
clause does not run again.
In respect to past-due premiums, there is a legitimate argument that there should be no
premiums due for past mortality charges as no coverage was provided during the lapse
period. Therefore, some jurisdictions limit the past-due premium to the increase in
reserves between the time of lapse and reinstatement.
Incidentally, reinstatement is not permitted if the policy has been surrendered (or
continued as extended term insurance) and the full term of the policy has expired. If
the extended term portion has not expired, most companies will reinstate the policy with
little or no evidence of insurability. Regardless, reinstatement seldom is allowed if
more than 5 years has elapsed since the policy lapsed.
MISSTATEMENT OF AGE
Policies are required in most jurisdictions to have a misstatement of age provision
which simply states that if the insured’s age is found to have been misstated, the
amount of insurance will be adjusted to be that which would have been purchased by
the premium paid, if the correct age were known.
If the misstatement is determined when the policy is in force, and if the age is
understated, usually the insured has the option to pay the difference in prem ium with
interest or having the policy reissued at the proper amount to match the premium. If the
age is overstated, a refund is usually made by paying the difference in reserves.
The same rules hold if there is a misstatement of sex – not a usual situation, but it could
happen through error in transcribing.
This provision appears in policies so that a misstatement of age cannot be considered a
misrepresentation and thus be used to void the policy.
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RENEWAL PROVISIONS
Life insurance policies can be continued by payment of premiums in a timely manner
and for the length of time contracted. Most individual life insurance policies stipulate
the guaranteed maximum premium that can be charged by the insurer. In other types of
insurance there are differing types of renewal rights, such as non-cancellable,
guaranteed renewable, and conditionally renewable. As important as these are in health
insurance, they have little, if any, application in life insurance.
O PT I O N A L R I D E R S / B E N E FI T S
The Riders discusseds in this section are optional, however, if underwriting requires a
rider to be attached to a policy, the policyowner would be advised in advance. Some
Riders are mandated by law. Riders are even used for substandard risks, as anytime
that the premium is increased for underwriting purposes, the insured is informed by a
Rider so stating. These types of Riders are not discussed in this section as they are not
“typical” riders.
WAIVER OF PREMIUM
The waiver of premium rider allows the policy to continue without further premium
payments if the insured becomes disabled and cannot work. In essence, the insurer takes
over the premium payments. The key to this rider is understanding what the insurer
means by disability.
 Total disability is the inability of the insured to perform any and all important daily
duties of that insured’s occupation.
Most companies require 6 months of continuous disability before the waiver of
premium (WP) provision applies. A disability is covered if it begins prior to age 65
(usually) and will continue as long as the insured continues to be disabled.
WP is not a continuance of premium, but is a benefit for which there is a premium.
Therefore dividends continue (if participating policy), cash values continue to increase,
and loans may be obtained. Actually, it is a benefit that pays an amount exactly equal to
the premiums when the insured becomes disabled.
Benefits will not be paid if the disability results from:
• Commission of a crime by the insured.
• War or other military action.
• Self-inflicted injury.
There are 3 different provisions regarding WP riders on Term policies when conversion
is involved to a permanent plan:
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1. If the insured is totally disabled, the term policy premiums will be waived, but if the
policy is converted, the premiums will not be converted on the new permanent
policy.
2. Some companies will honor the waiver of premium on the new permanent policy.
3. Some companies provide for a waiver of premium on both the term policy and the
permanent policy, provided the conversion occurs at the end of the automatic
conversion period (when the new permanent policy automatically goes into force,
and premiums on the new policy are waived).
Payor Rider
The Payor Rider is a form of Waiver of Premium, and is usually written on po licies
insuring children, or when another person pays the premiums. With the payor rider, if
the person paying the premiums either becomes disabled (under the same conditions
described for the waiver of premium rider) or dies, premiums are waived. Disabil ity or
death must occur before the child reaches a certain age, usually 21 or 25. Some payor
riders, instead of waiving the premiums for disability, do so only if the payor dies.
Payor riders generally require a medical history and exam for the person who is paying
the premiums since it is this person's health, not the insured child's health, that could
activate the waiver.
Premium Waiver and Universal Life
When the waiver of premium rider is attached to a universal life policy, the rider works
differently than with whole life or term. The usual approach is that the insurer waives
only the portion of the premium payment that actually pays for the insurance protection,
the mortality charge. Some insurers do offer a universal life waiver of premium rider
that calls for the insurance company to pay the entire premium. This is obviously
advantageous since cash values can continue to grow as originally anticipated. The
amount the company pays is limited to the planned premium established when the
policy was issued.
Accidental Death
The Accidental Death Rider (also known as “Double Indemnity), when added to a life
insurance policy, provides that double (or triple) the face amount of the policy, will be
paid if the insured’s death is the result of an accident. Philosophically or financially,
there is no reason that a person that dies from an accident should receive so much more
insurance benefit, than one who died of disease. The popularity is principally because
it is relatively inexpensive, and many people just “feel” that they will die from an
accident (actually, less than 10% of all deaths are the result of an accident). If there
were no Double Indemnity provisions, think of all of the murder mysteries that would
not have been written…
Accidental Death is typically defined in a policy as “death resulting from bodily injury
effected solely through external, violent, and accidental means, independently and
exclusively of all other causes, with death incurring within 90 days after such injury.”
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The accident must be the sole cause of death, and if other factors contributed to the
death, in addition to the accident, the rider does not apply. Both the “cause” and the
“result” of the death must be accidental.
Death must occur no more than 90 days (or three months) after the accident or, under
some riders, 120 days. Some courts have held that the 90 day period does not have to
be strictly applied. Accidental death coverage usually expires at age 65 (or 70).
Premiums are based upon age at issue (usually 5-year banded).
Certain exclusions apply (three are the same as for the WP Rider, plus the following):
 Death from an accident accompanied by illness, disease or mental illness.
 Death from aviation accidents except when the insured was a paying passenger
on a common carrier.
 Death by accident while the insured was under the influence of alcohol or other
drugs.
 Death resulting from circumstances that do not appear to be accidental - an
exclusion that might require legal action to prove or disprove accidental death.
Insurers list the circumstances that apply.
Accidental Death and Dismemberment
Some companies offer an accidental death and dismemberment rider which has the same
features as the accidental death rider, plus a benefit paid if the insured suffers
accidental dismemberment of specified parts of the body, rather than death. The rider
usually applies to loss of eyesight and loss of members such as arms, legs, hands and
feet.
A typical benefit schedule would be as follows (“principal sum” is the face amount of
the benefit rider):
Loss
Amount Paid
Sight in both eyes
Principal sum
Sight in one eye
Half of principal sum
One member
Half of principal sum
Two members
Principal sum
Disability Income Rider
Similar to the waiver of premium rider, the Disability Income Rider pays a monthly
income directly to the disabled person. The insured must be totally disabled to receive
payments and the definition of disability follows the standards described for waiver of
premium. The same exclusions also apply.
Disability income riders provide a relatively modest amount of income per $1,000 of
life insurance coverage - commonly $5, $10 or $15 per $1,000. Most companies also
require a three- to six-month waiting period following disability before monthly
payments begin. Alter the waiting period, payments are retroactive to the first day of
disability.
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ACCELERATED DEATH BENEFIT RIDER
The Accelerated Death Benefit rider (may also be a policy provision) provides for the
payment of all or a portion of the death benefit of the policy prior to the death of the
insured if the death of the insured is caused by some specific medical condition. There
are three types of Accelerated Death Benefits riders.
Terminal Illness
The Terminal Illness coverage provides that a specific percentage of the face amount,
such as 25% or 50%, will be paid (frequently with a maxmim of $250,000) if the
insured is diagnosed as having a terminal illness. Generally, the coverage will specify
that the insured have no more than 6 months to live, others may use one year as the
maximum. This terminality of the illness must be proven by a physicians certification,
as well as a hospital or nursing home, &/or a medical exam ordered by the insurer.
Insurers usually notify beneficiaries and assignees of the acceleration. Dividends and
cash values, plus death benefits and premiums, will be red uced by the accelerated
percentage.
Catastrophic Illness
The Catastrophic Illness coverage closely resembles the Terminal Illness coverage,
except that the insured must have been diagnosed with one of the specified diseases
(also known as “dread diseases”), such as stroke, cancer, heart attack, coronary artery
surgery, renal failure, etc.
This coverage is not as available as it once was, as the marketing of this option has
been criticized heavily by insurance departments and other officials because of “fe arbased” selling and claims difficulties. The NAIC has published Accelerated Benefits
Guidelines for Life Insurance, which specifies the illustrations that must be provided
for prospective purchasers.
Long Term Care Coverage
The Long Term Care Coverage type of accelerated death benefit, provides that monthly
benefits will be paid if the insured is confined because of a medical condition.
Qualifications are strict, and the insured must be confined in a qualified facility and the
confinement must be medically necessary.
Provisions vary, and can cover skilled nursing facilities, intermediate nursing care
facilities and custodial care facilities. Some cover home health convalescent care.
The elimination period can be 2 to 6 months, and some insurers requ ire that the policy
be in force for a specified number of years.
The monthly benefit typically equals 2 percent of the face amount of the life insurance
policy, subject to a specified maximum amount and a specified total maximum payout.
Some companies use a “two-tiered” approach, so that the percentages are reduced in
relation to the face amount, such as 2% of the first $100,000 of face amount, ½% of the
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amount over that. The maximum payout is generally 50% of the face amount of the
policy.
NOTE: Some financial planners have suggested a Long Term Care rider on a life
insurance policy, instead of a long term care insurance (LTC) policy. There is a danger
in this, as in many situations, it is less expensive to purchase a life insurance policy and
a long term care insurance policy (both). In addition, the LTC policy has much more
flexibility and more benefits.
GUARANTEED INSURABILITY
The guaranteed insurability or purchase option rider guarantees future opportunities for
insureds to purchase additional insurance without proving they are still insurable. This
rider may used with cash value policies only (not term), and typically may be used only
to purchase more cash value coverage.
Guaranteed insurability riders are offered to younger people who are m ore likely to
remain healthy. The option to purchase more insurance without proving insurability
ends at the insured’s age 40 or any other age stipulated by the insurance policy.
The insurer offers a number of “option dates” on which the insured may elect to
purchase the additional insurance. Option dates are usually about three years apart and
the number available to a given insured depends upon the insured's age when the rider
is purchased and the age at which the option expires. For example, with thre e year
periods and an option ending at age 40, a 25-year-old could purchase additional
coverage at ages 28, 31, 34, 37 and 40, with five option dates available. A 34 -year-old
would have only two, at ages 37 and 40. Some insurance companies permit the
purchase of additional coverage ahead of the stipulated option date when the birth of a
child occurs. Riders with this provision cost more than the standard rider.
Each insurer establishes certain minimum additional amounts of coverage, such as
$5,000 minimum plus additional increments of $1,000. The maximum amount of
additional insurance permitted is the amount of the original policy's death benefit.
While this rider guarantees that the insured will be able to buy coverage without
proving insurability, the insured's attained age is used to determine the cost, so there
are no guarantees about the cost of the coverage.
COST OF LIVING RIDER (COLA)
The Cost of Living Adjustment rider helps the amount of insurance to correspond with
inflationary increases, measured by the consumer price index (CPI). For example, if
the CPI rises 1.5% over a year's time, the policyowner may purchase more insurance
equal to 1.5% of the policy's face value. An upper limit applies, typically 10% of the
face value.
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Cost of living riders usually allow the purchase of one-year term insurance added to a
whole life policy. Some permit a small amount of whole life as paid -up coverage and
others might allow a combination of one-year term and the paid-up addition of whole
life. If the policy is universal life, the death benefit is simply increased. The COLA
rider is usually available only with cash value policies, rarely with term insurance.
The policyowner may choose to activate the cost of living rider or not, but must
specifically decline it if no additional coverage is desired. Under universal life
policies, policyowners must be very clear about their desires because if they skip a
premium the insurer will automatically adjust the cash value account to pay both the
premium and the cost to adjust the death benefit to the CPI.
TERM RIDER
Term Riders attached to a life insurance policy to enhance the benefits have been
briefly discussed earlier in this text. Term riders may be attached to cash value policies
only and the period during which the term rider is in effect may not be longer than the
premium-payment period of the cash value policy. The cost of the term rider is added to
the cost of the cash value policy so the policyowner pays a single premium.
Term riders are less costly than separate term policies, but they may be purchased only
in conjunction with a cash value policy, so the total cost is greater.
Once the term rider is purchased, the insured may not let the cash value policy lapse
and simply maintain the less costly term rider. An insured may, however, cancel the
term rider while maintaining the cash value policy, although this practice is
discouraged.
The term rider may provide level term coverage, or increasing or decreasing term
coverage. Most purchasers in today’s market, purchase the coverage to be added to the
base policy so they can purchase a high-value term life insurance rider, or a rider that
permits them to make additional premium payments to accelerate the cash value
buildup, which may or may not increase the death benefits.
STUDY QUESTIONS
Chapter 3
1.
Settlement Options
A.
are the exclusive right of the beneficiary.
B.
are determined by the insurance company at the time the policy is issued..
C.
determines how the proceeds of a life insurance policy will be paid.
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2.
3.
4.
5.
6.
7.
8.
The beneficiary receives an income for the rest of their life under
A.
the life income option.
B.
an interest only option.
C.
a fixed amount option.
A transfer by the policyowner of all rights in his/her life insurance policy
A.
is illegal.
B.
can only be accomplished by withdrawing the cash value and transferring the
cash.
C.
is called an assignment.
When an insured becomes terminally ill, he/she may sell his/her policy. This is called a
A.
collateral assignment.
B.
viatical settlement.
C.
settlement option.
If the owner of a traditional life insurance policy wants to borrow from the policy he/she
A.
can borrow up to the face amount of the policy.
B.
can borrow nearly 100% of the cash value.
C.
must get the consent of the beneficiary.
The reinstatement clause of a life insurance policy
A.
allows premiums to be paid with 31 days of the due date.
B.
allows the policyowner to reinstate a policy that has lapsed.
C.
is available to the policyowner at anytime after a policy lapses.
The misstatement of age provisions
A.
allows the insurance company to void the policy.
B.
requires the insured to reapply for the insurance using the correct age.
C.
is of benefit to the insured.
A waiver of premium rider
A.
is mandated by law.
B.
allows the policy to continue without further premium payments if the insured
becomes disabled and cannot work.
C.
is paid if the disability is self-inflected.
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9.
10.
11.
12.
13.
14.
If an insured becomes disabled and the Waiver of Premium applies; then
A.
the policy is considered paid up.
B.
the insurance company pays a monthly benefit to the insured.
C.
cash values continue to increase and loans can be obtained.
A term rider
A.
attaches to a life insurance policy to enhance the benefits.
B.
attaches to a life insurance policy at no charge.
C.
cannot be cancelled without canceling the cash value policy.
If a life income option with a period certain is selected by the policyowner the insurance
company
A.
pays the death benefit in such a way that the beneficiaries receive an income for
the rest of their lives.
B.
will pay benefits in installments first to the primary beneficiary. If the primary
beneficiary dies before the pre-determined period, then the contingent beneficiary
receives the payments.
C.
will pay benefits for a pre-determined fixed period of time.
If there is a “collateral assignment” of a life insurance policy to a lending institution as
collateral for a loan
A.
the policyowner can borrow from the policy.
B.
the lending institution keeps the entire death benefit, even if the loan has been
paid.
C.
the lending institution collects the proceeds at death.
If a policyowner borrows from a life insurance policy
A.
the loan is expected to be repaid.
B.
there is no interest charged.
C.
the cash surrender value is not effected.
If a “disability income” rider is added to a life insurance policy, and the insured become
disabled, the
A.
insurance company will pay the premiums on the policy.
B.
insurance company pays a monthly income to the disabled person.
C.
death benefits will be reduced by the amount the insurance company paid for the
disability.
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15.
The accelerated benefit of Long-Term Care Coverage
A.
us part of all life insurance policies.
B.
provides that monthly benefits will be paid if the insured is confined because of a
medical condition.
C.
takes effect when the first premium is paid.
Answers to Chapter 3 Study Questions
1C 2A 3C 4B 5B 6B 7C 8B
9C
10A 11B
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12C
13A 14B
15B
CHAPTER FOUR - TRADITIONAL LIFE INSURAN CE
T E R M L I FE I N S U R A N C E PO L I C I E S
Term insurance is discussed first as it is the simplest form of insurance, actually the
basic form of life insurance. Term life insurance provides either level or decreasing
death benefits, and in some cases, increasing death benefits (usually a “rider” to a
policy). The majority of life insurance sold in the U.S. – and probably worldwide also
– is term insurance, which provides for a level death benefit over the period of the
policy, with either level premiums or with premiums that increase with age (as
discussed previously).
RENEWABLE TERM POLICIES
When a term policy has level death benefits and with increasing premiums, they are
considered as renewable term policies. The yearly renewable term policies (which are
also known as annual renewable term) are the simplest forms of term policies. There
are also five-year, 10 year and 20 year (and other policy periods) renewable term
policies available (all increasing premium policies).
Some insurance companies have recently moved away from yearly renewable term
(YRT) policies as these policies traditionally have high lapse ratios and low premiums,
leading to unprofitable business. Premiums are low as competition for YRT and similar
policies that have no benefits other than death benefits, are purchased on a cost basis
mostly, leading to recent “rate wars.”
In addition to lower premiums, companies differentiate in their pricing in other areas,
such as different premiums for smokers and non-smokers. This discount for nonsmokers can be substantial, as much as 50% with some companies. When the
smoker/non-smoker premiums were developed for general use several years ago,
actuaries took into consideration the difference in mortality between smokers and non smokers, and decreased the premium for non-smokers to create a block of “preferred”
risk insureds. Logically, if those with better mortality were to be removed from the
general “population,” then those remaining would be considered “sub -standard” and
should pay higher premiums. When companies even suggested raising premiums on
smokers, there was howls of protest from the marketing departments, with the result
that if a company raised the premiums on smokers, their agents would write non smokers and (unless they were “captive” agents) would place the smokers with those
companies that did not differentiate or did not have separate premiums for smokers and
non-smokers. This would mean that those that accepted the smoker risks would suffer
worse mortality than expected particularly those who made no distinction.
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Another method of pricing differently was the introduction of a reentry feature. The
insured may be allowed to “reenter” the lower priced group of policyowners (those that
have reentered) periodically, typically once every 5 years. The insured will have their
premium lowered if they resubmit evidence of insurability at that time. Technically,
those who enter at the end of the reentry period will have their premium reduced to
premiums that are based on first-year select mortality for their attained age. A brief
explanation of “select” mortality should be of interest here.
Select mortality is derived from a table showing the mortality of only those persons
who have purchased insurance during the past year. These tables cl early show that
such people have a much lower mortality rate in the years immediately following
their purchase of insurance, than those who have been insured for some time
because they have recently passed medical (and other) tests, and, of course, because
they are younger. The mortality “curve” which shows the increase in mortality as
individuals age, will show much lower mortality on a select basis, than on the
general population (called an Aggregate Mortality table), and of those of the entire
group exclusive of the initial period after purchasing life insurance (Ultimate
Mortality table).
CONSUMER APPLICATION
John, age 40, considers purchasing a $100,000 of term insurance with no reentry
feature, with a premium of $185. He also considers a policy with a 5-year reentry
feature, with the initial premium of $138. However, at the end of 5 years, the nonreentry premium would be $228. However, with reentry (submission of evidence of
insurability) the premium would still be $138, a 25% savings over the reg ular term. He
must also take into consideration whether he believes he will continue to be in good
health at future reentry dates.
LEVEL PREMIUM POLICIES
Term insurance may be written for a specified period of years – typically 10 and 20
years, or to age 65. These policies have become quite popular in recent years as there
has been so much interest in investing in the stock market that the difference in
premium between permanent insurance and level premium term policies makes more
funds available for investment.
There is a product available, called life-expectancy term that provides level premiums
for the expected lifetime of the insured, according to the specified mortality tables.
This would lead to some cash value (non-forfeiture value laws apply), but the cash
value increases to a point, and then decreased to zero by the end of the policy period.
Term-to-age-65 (or a later age, such as 70) provides insurance for a shorter period of
time than do the life-expectancy policies, and is used mostly for life insurance
protection during the working years of the insured. The cash values perform as with
life-expectancy term.
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VARYING FACE AMOUNT TERM INSURANCE
Decreasing Term where the face amount decreases over time is sold in significant
amounts in the U.S. One of the primary uses of decreasing term is for mortgage
protection. With these policies, the face amount decreases each year in the same
amount that the mortgage decreases, therefore in case of death before the mortgage is
satisfied, there will be sufficient funds for the heirs to pay off the mortgage in full.
Term that decreases in the same amount each year of the policy period is used for a
variety of purposes, and may be used for mortgage protection also. The disadvantage of
using decreasing term per se for mortgage protection is that the death benefit does not
exactly match the decrease in the mortgage amount. As anyone who has ever had a
mortgage can attest, during the early years of a mortgage, the mortgage amount
decreases very slowly because of interest on the unpaid amount. Therefore if an
insured would die in the early years of a mortgage, a decreasing term policy would be
considerably short of providing all the funds to retire the mortgage.
Another type of decreasing term is the payor benefit rider on a policy, which insures
the life of a juvenile. The rider provides a death benefit in case of the death of the
premium-payor, which would pay the exact premium to keep the juvenile policy in
force until the juvenile insured reaches age 21.
The family income policy (it can also be sold as a Rider) provides funds to be paid to a
surviving spouse until a certain age or for a predetermined period of time (10, 15, 20
years, typically). It is sold as protection during the time that children ar e being raised,
and the policy then expires.
Increasing Term insurance is seldom sold as a policy, but is usually sold as a rider to a
permanent plan of insurance. In the past, during inflationary times, it was popular as a
Cost of Living Adjustment rider, which would provide for automatic increases in the
policy death benefit calculated by a designated index, such as the Consumer Price
Index. There is no evidence of insurability required as long as the insured continues to
accept the added premium and increased death benefit each year. A separate premium
notice is mailed each year for this rider. A decline in the cost of living is not reflected,
but the amount of the previous year is automatically transferred to the present year.
A return-of-premium rider is also available, which returns an additional amount of
death benefit equal to the premiums paid for the insurance, if the insured dies within a
stipulated period of time. This is a misnomer, as there really is no “premium returned,”
but the death benefit increases each year by the amount of the premium paid, with the
increases “financed” by an increasing term rider. This rider is primarily used in
business situations.
Increasing term insurance may also be purchased by dividends, thereby providin g an
important source of needed additional coverage and can be used advantageously in
business situations.
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ENDOWME NT INSU RAN CE
Prior to 1984, endowment insurance was used by many as a savings vehicle. In 1984,
the tax laws pretty much limited endowment policies to qualified retirement plans, but
even before that, endowment plans were having difficulty competing with whole life
and term insurance, primarily because of the high first-year expenses related to
endowments.
There are many endowment policies still in force in the U.S., and a retirement income
endowment was a well-known use of the endowments that paid either the death benefit
or the cash value at death, whichever was greater – and is still used in some pension
plans. A semi-endowment policy pays half of the death benefit if the insured survives
the policy period.
In the 1970’s, deposit term was popular and some agents and agencies became wealthy
promoting this plan. Although it is a term policy, it provided for the payment of an
endowment that was equal to a multiple of the difference between the high first year
premiums and the renewal premiums. By increasing the first year premium (deposit),
premiums for the rest of the policy period would be lower because of the projected
interest on the “deposit.” Actually, this plan was so misrepresented and so confusing to
policyowners, that it soon became unpopular with regulatory bodies.
Juvenile Endowment policies are not popular in the U.S. but are sold in large amounts
in foreign countries. They provide expenses for a child’s education, marriage or
independence. Education endowments are very popular in Japan and Korea. Obviously
Universal Life and other variable products can provide this type of coverage, and at a
lower price.
W H O L E L I FE I N S U R A N C E
As discussed earlier, whole life insurance pays a death benefit (face amount) upon the
death of the insured, regardless of when that might be. For study purposes in this text
and following definitions used in many other texts, “whole life insurance” is defined as
any type of life insurance that can be maintained in effect indefinitely. Universal Life
insurance can be considered as whole life if there are sufficient cash values.
Whole life insurance generally is priced on mortality statistics that a ssume that all
insureds die by a certain age, as illustrated and discussed earlier. Age 100 is commonly
used, and those who live to age 100 can receive the full -face amount as if they had died.
It is often viewed, as term-to-age-100 as actuarial calculations are based on the
assumption that everyone that may survive to age 99, will die that last year.
59
O R D I N A R Y L I FE I N S U R A N C E
While the terms are used interchangeably at times, ordinary life insurance is always
whole life insurance, but whole life insurance is not always ordinary life insurance (as
discussed below). Ordinary life insurance provides whole life insurance because the
premiums are payable for life. This form of insurance is also known as straight life,
and continuous-premium whole life, usually depending upon which is being compared
to ordinary life.
Basically, ordinary life policies provides permanent protection at an affordable
(usually) premium. This is because the costs of mortality are spread throughout the
entire policy. As anyone experienced in life insurance knows, premiums vary widely
for reasons other than age or face amount, such as by dividends (if any), larger or
smaller cash values, and excess-interest credits for certain types of policies. It is also a
fact of life, whether one admits it or likes it; name recognition of the insurer can have
an effect on the premiums. A lower premium is the only way some not -well-known
companies can compete with the more advertised and better known insurance
companies.
The traditional whole life policies have lost a lot of market share to newer -generation
interest sensitive products, such as Universal Life and Variable Universal Life
(surprised?). These new products were introduced when interest rates were relatively
high and agents were able to use projections showing larger interest growth than
traditional life. Many, too many, insurers believed that the high rates shown in the
illustration would continue, so when the interest rates fell, the actual results did not
meet the results expected by the insureds, leading to a lot of “undesirable
consequences” and lawsuits. The use and abuse of financial projections are discussed
later in this text.
Companies issuing traditional participating whole life policies were not affected so
severely because they could credit higher rates of interest through dividends. These
interest rates are predicated on the interest received on the entire portfolio of the
company, and portfolio rates change much more slowly. Therefore when interest rates
fall, Universal Life products do not fare as well as traditional policies.
To compete better, companies offering traditional whole life introduced flexible
provisions such as allowing the policyowner to determine their own future premium
payments (within company and tax maximums and minimums). As an example, so that
the insured can pay a lower than usual premium, low-load term riders with face amounts
of (up to) 10 times the basic face amount was created.
CONSUMER APPLICATION
James, who just turned 35, purchases an ordinary life policy with a face amount of
$100,000. The premium would be $1,500. However, using a combination of term rider
and ordinary life, a rider can reduce the annual premium to $500. The insurance
company offered to reduce the premium to any amount between $1500 and $500.
60
The policy is participating, and combining paid-up additions from the dividend and
adding an increasing term rider, the company could provide a level death benefit with
lower than usual premium.
James wanted his premium to be fixed so that he could budget for it and he was
concerned that the projected dividends may not be realized, so he opted for the first
plan.
If future dividends and surrenders of paid-up additions are sufficient, theoretically the
policy is now self-sustaining, so after so many years, an insured can have the premium
paid. This is called vanishing premiums and which is, in fact, erroneous. Note the
first word of above sentence (IF), if the dividends are lower than those assumed
initially, the policyowner will be called upon to resume premiums. Unhappy
policyowners! (This is also discussed later in the section of interest -sensitive
products). This same system is used with non-participating policies with nonguaranteed benefits.
A policy deposit rider is used by some companies, whereby a policyowner deposits an
amount to pay future premiums (providing sort of a “cleaned -up” deposit term).
Therefore the premiums will be paid by the rider at some time in the future. (An
immediately annuity is sometimes used to accomplish the same purpose).
LIMITED PAYMENT WHOLE LIFE
With a limited payment whole life policy, the policy remains in full force for the
“whole of life” but premiums are paid for a limited period of time only. After that
point, the policy becomes fully paid-up. For definition purposes, a policy matures when
the face amount is payable, usually at death. A policy expires when the term of the
policy expires and there is no benefits payable, such as in term insurance.
Premiums for these types of policy are typically 10, 15, 20 or 30 year, or to age 65 or
similar age. Because the premiums for these types of policies are (comparatively) high,
there is not much demand in the individual life insurance market; however, limited
payment policies can be used in business situations where it is important that the policy
be paid-up within a certain time frame.
Single premium whole life policies are those whole life policies where, as the name
implies, the entire premium for the life of the policy is paid from inception with a
single payment. As one can imagine, the cash value of the single premium policy is
substantial from the date of the policy. Because of the high premiums, these policies
are not frequently sold but are used for special situations.
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CONSUMER APPLICATION
Bertha, age 55, had 4 small-face-amount policies which were taken out when she was a
child, by her parents and doting grandparents, and when she was first married. These
policies were either endowment policies (3) or limited pay life ( 20-pay life). Totally,
there were cash values of $25,000 (which had been considered a lot of money when she
first was insured). The cash values were credited only with 3% interest.
Bertha was a widow and wanted to make sure that her burial expenses wer e covered by
insurance, and she wanted to leave a small amount of money to a nurse that had helped
her in the past few years. She is uninsurable now so she could not get a new policy.
Bertha, upon the advice of her agent, “cashed in” the policies, and rec eived the
$25,000, which she immediately used to purchase a single premium policy. Since she
met the requirements for a Section 1035 exchange (non-taxable), when she died there
was sufficient (approximately $10,000) for her burial, the remainder going to her nurse.
She no longer had to worry about burial expenses.
C U R R E N T A S S U M P T I O N W H O L E L I FE I N S U R A N C E
A current assumption whole life (CAWL) provides a “bridge” between traditional
insurance and interest sensitive “new generation” products. In effect, a CAWL is called
“interest sensitive whole life” by some, and also called “fixed -premium whole life” by
others. The CAWL provides non-par whole life insurance under a more modern
“transparent” format. Generally the policy will use interest rates that refl ect the newmoney rates and will also use the current mortality charges in determining the cash
value. While more traditional whole life policies use dividends as a means of passing
to the policyowner any changes in assumptions used in the pricing of the original
policy, CAWL uses changes in the cash value and premiums to reflect the changes in
the company expense and interest criteria from that that is guaranteed inside the
contract.
Because CAWL policies are “unbundled,” much like Universal Life, ther e is a stated
allocation of premium payments and interest earnings to the mortality charges, expenses
and cash values. Contract this with the traditional whole life policy, where the
policyowner has no idea as to how these funds are allocated.
To be specific, the premiums paid are charged for expense charges, and the remainder is
a (net) addition to the policy fund. This is added to the previous policy fund balance
and any interest (at the current rate) that has accumulated on the fund. From this fund
total, a mortality charge is made, and the remaining amount is the year -end fund
balance. This balance less any stipulated surrender charges would be the net surrender
value if the policy were to be surrendered.
The CAWL can be either a low-premium plan, or a high-premium plan.
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CAWL Low -premiu m Plan
The initial indeterminate premium is lower than that of a traditional ordinary life
policy and the policy has a provision that allows the company to “re -determine the
premium using either the same or other (new) assumptions for future mortality
and/or interest, within the guaranteed assumptions in the policy.” When the
premium is re-determined, so that it combines with the existing account value, will
be sufficient to maintain a level death benefit for the l ife of the policy (if the new
assumptions are proven correct). If these new assumptions are higher or lower than
those used at the time of issue, the premiums will be either higher or lower – if they
are the same; the premium will remain the same.
If the new premiums are lower than the previous premium, there are three options
available to the policyowner:
1. The policyowner may pay the new (lower) premium and keep the previous death
benefit. (The usual choice.
2. The policyowner may elect to continue to pay the previous premium, maintain
the same death benefit, and pay the difference into the fund.
3. The policyowner may continue to pay the previous premium, but use the
difference to purchase an increased death benefit. If this option is used, the insured
may be subject to evidence of insurability.
CAWL High -p remi um Plan
If the premium is higher than the previous premium:
1. The policyowner may pay the new (higher) premium and keep the previous death
benefit.
2. The policyowner may elect to continue to pay the previous premium, but accept a
lower death benefit that can be paid-for by the new higher premium.
3. The policyowner may continue to pay the previous premium and keep the same
death benefit, using some of the cash value to pay the additional premium. This
option is usually available only if the account is at a determined level for at least 5
years in the future.
The high premium plan is as the name implies, relatively high, however there is a
guarantee that the premium will not exceed a stated amount. Some of t he policies
offer a vanishing premium concept which states that the “vanish” will continue as
long as it is greater than the minimum cash value. Policyowners have been known
to confuse the “may vanish” in this option, with a paid-up life policy where the
policy has no more premiums to be paid.
There are many variations of this policy, some of short -lived duration. The principal
difference between the CAWL and Universal Life is that the CAWL has a required
premium, making it easier for companies to administer, and the company has a greater
control over the cash value buildup. One of the principal advantages in the mind of
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many people is that it “forces” the payment of an established premium amount. One of
the well-established advantages of life insurance as a savings or investment vehicle is
that many people do not consider themselves (and probably rightfully so) as having the
personal discipline to pay flexible premiums.
MODIFIED LIFE INSURANCE
A Modified Life insurance policy is a whole life policy with the early premium (from 1
to 5 years) considerably lower than the typical whole life policy and with higher
premiums after the modified period. Some policies charge 50% of the usual premium
for a period of 3 or 5 years, and then charge the higher premiums.
There are two types of modified life policies that are highly advertised and considerable
premium has been generated with these policies. The principal type is used for “ senior”
citizens and sold usually in units of $1,000 or $10,000 and are sold primarily to be used
for final expenses. These policies may have either no premium for the modified period
– 1 to 3 years –or a very low premium. The health questions are very simple and there
is little, if any, underwriting, as the premium is loaded for the extra mortality. But the
big difference between these policies and similar modified plans is that if there is a
death during the modified period, then the beneficiary will receive only the return of
premium. Most states now require that those plans that offered this plan must contain
an accidental death benefit of the face amount, or a multiple thereof during the modified
period. Otherwise these plans could not be considered as “life insurance.” Makes sense
The second type is not as prevalent now as it once was. It is offered to substandard
risks, and the original plan would accept any person with no evidence of insurability.
There was a premium during the modified period (some offered reduced premiums) and
in most respects, the plan was identical to the Senior plan discussed in the previous
paragraph. If the insured lived past the modified period, any serious health problems
would either have been resolved, or the insured would have died, and in which case the
beneficiary received the premiums paid (the insurance company kept the interest on the
premiums). Eventually, there were a very few health questions asked, such as previous
or present episodes of cancer, heart attack, or being hospitalized within the past 6
months (or similar period). Interestingly, prior to these questions being asked, one
company’s actuary insisted that the agents could actually accept anyone in a “cancer
ward.” While technically and actuarally this may have been correct, the company
management could not bring themselves to market in this area.
“ENHANCED” LIFE INSURANCE
The enhanced life policy is a participating whole life policy that uses dividends to
reduce the premiums of the policy. There are several variations but perhaps the best
known is a whole life policy whose premiums are reduced after 5 years (usually), but
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the face amount stays level because the dividends are used to purchase paid -up
insurance so that the face amount remains level.
If the dividends are not quite adequate to meet the premium requirement s, then the
dividends are used to purchase one-year term. If they are more than adequate, the
excess is used to purchase paid-up additions (so the face amount may be higher).
GRADED PREMIUM WHOLE LIFE
Graded Premium Whole Life policies are similar to Modified Life policies described
above and are often sold for the same purpose. The typical Modified Life policy
charges premiums that are 50% of the usual premium for a whole life policy, and
increase incrementally over the next time period (5 to 20 years) , and then they remain
level thereafter. Cash values do not grow as rapidly as with whole life and may not
appear for 5 years or so.
There are variations, such as an YRT policy that has increasing premiums for a
specified number of years, and level thereafter. Actually this is an YRT policy that
automatically converts into a permanent whole life after the term period. This is useful
for those who can afford to pay for protection in an increasing amount each year, but
then wants a level premium later, such as retirement or after reaching some financial or
lifestyle goal.
DEBIT INSURANCE
Dating back to England in the 17 th century, debit insurance was the major type of life
insurance sold in the U.S. until the beginning of the 20 th century. Also called
Industrial insurance, it was sold in small amounts, usually no more than $2,000, and
was sold door-to-door by “debit” agents who had their own territory – called a “debit”
because the insurance agent would accept the payment (usually weekly, then later
monthly) and then “debit” the insured’s record for the premium payment. In today’s
market, debit insurance usually applies to any type of insurance sold through home
marketing.
Debit insurance has lost its appeal as $2,000 does not go far today and the p remiums are
relatively high compared to other permanent insurance. Debit insurers have received
bad publicity because their premiums are so high; however the principle reason that
premiums are high is that the persistency is not good, as the lapse rate is very high.
Many debit customers drop the insurance for a month or so if finances become tight,
and then start again when they have a few dollars available. Today most of the
companies are called home service life insurance companies, which is an appropriate
name, and most of their “debit” insurance is monthly debit ordinary which are ordinary
life policies written for amounts of $5,000 to $25,000, usually with premiums collected
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monthly at the policyowners home, although some policyowners make monthly
payments regularly at the local insurance office, or they mail the premiums monthly.
It is fully expected that debit insurance will continue to decrease as group insurance has
replaced much of the debit insurance. There has also been considerable legislati on
restricting the marketing and provisions of debit insurance, with the result that much of
the profit of this business has disappeared.
FAMILY POLICY
A Family policy is a policy or a rider on a contract, that provides for whole life
insurance for the father or mother, and with term insurance for the other family
members. The coverage on the spouse and children can be a specified amount of
insurance, or it can vary by age. The amount of life insurance is often measured by a
“unit,” typically $1,000 of coverage per unit for spouse and children, and $5,000 per
unit for the principal insured.
The premium for a family policy typically will remain level, regardless if there are
additional children, and is based upon an average number of children. This co uld prove
inexpensive coverage if there are several children or expensive if there is only 1 child.
JUVENILE INSURANCE
Typically, Juvenile Insurance is a whole life policy issued on the application of the
parent or other responsible person, on the life of a juvenile. Most juvenile policies are
written on children who are at least one month old and the applicant controls the policy
until the child reaches the age of 18 (usually) or upon the death of the applicant,
whichever comes first.
The purposes of juvenile insurance are many, but principally it is used for guaranteeing
a college fund to the child entering college, or at least there will be a cash value that
can be used for college purposes. It is also frequently used to guarantee that there will
be some life insurance for the child even if the child becomes uninsurable later.
Many agents and financial planners insist that it is better to use the funds that would go
to pay the premiums on a child, for the purchase of additional coverage on the
“breadwinner” under the theory that there is little “financial” loss that will occur in the
death of the child, and only the death of the breadwinner will cause a financial
hardship.
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BURIAL INSURANCE
Burial insurance is also called “Pre-need Funeral Insurance” by some of those in the
business, as it is felt that “burial” is a small part of the final expense of the insured,
undoubtedly true. This policy provides that a fund will be made available for final
expenses, and in most cases, it is used to fund a prearranged funeral. The funeral
provider (usually a funeral home) agrees to furnish certain services and articles for the
funeral, including casket and in many cases, even a burial plat, for the amount of the
policy.
These policies are usually sold to persons 65 to 70, and provide $2,500 to $10,000 of
coverage – frequently a single premium whole life policy.
There were considerable concerns about these policies, as some consumer advocates
believe that the funeral companies were taking advantage of older persons because they
were easily confused and did not understand that they were dealing with a life insurance
agent. The NAIC has since changed its advertising and disclosure model regulations to
include funeral insurance, with the result that complaints have diminished significantly.
MULTIPLE LIFE INSURANCE POLICIES
First-to-Die insurance, Survivor Life insurance, Joint and Last Survivor and Secondto-Die insurance are all forms of providing life insurance on two lives but with the
death benefit paid at the death of one of the parties. The death benefit is paid at the
death of the second survivor under survivor, joint and last survivor and second -to-die
insurance policies, but under the first-to-die coverage, benefits are paid when the first
person dies. (Did the names of these policies give a clue?) These policies are popular
because they are less expensive than other whole life policies on two lives; however
they really are not less expensive for the benefits they provide.
In the first-to-die policy, the policy may be less expensive than individual
insurance on two insureds. However, the insurance company only pays on the
death of one person, leaving the other person, who may actually be uninsurable
at that time, without insurance.
Second-to-die policies also pay off at the death of one person, but in this case it is the
death of the second person. This delays the time and chance that the company will be
called upon to pay a death benefit. Therefore, “actuarially” speak ing, the mortality
costs for life insurance in the policy are much less than in policies that covers only a
single life. The second survivor does not receive any benefits when the first person
dies, so the second survivor will have to pay premiums on a po licy that is now a single
life policy.
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These policies should not be considered as “bargains” but only as policies that can meet
the needs of a particular situation quite efficiently.
DISINTERME DIATI ON
Any discussion of traditional life insurance cannot be complete without the problems of
disintermediation being addressed.
 Disintermediation is the flow of funds out of one financial instrument, whose
interest rates are low, into another financial instrument whose interest rates are
higher.
In the early 1980’s, insurance companies experienced disintermediation as whole life
policies were surrendered for their cash values and these sums were then transferred to
higher-interest-paying noninsurance products. Because of these situations, interest
sensitive policies were developed by life insurance companies.
Because of the disintermediation, insurers had to liquidate bonds and other securities,
usually at significant discounts from par. Because of this, dividends paid at that time
on participating policies were not competitive with interest credits on current
assumption policies. Companies embarked on campaigns to alleviate the replacement
problem by making older policies more competitive in an effort to hold on to their
existing customers.
Previously, for many years, companies had a tendency to pay higher dividends than
what was necessary, but when the interest rates fell during the 1980’s, companies had to
reduce dividends and other interest credits, to a level below what was illustrated in the
policies. Some insurance companies (actually many companies) maintained higher
interest rate credits than were justified in an effort to keep their customer base. Some
companies began to invest in riskier investments (the riskier the investment, the higher
the income – usually) so as to stop the investment return decline.
Finally, during the early years of the 1990’s, nothing seemed to work for some of the
insurance companies, and there were some rather large – and several small – companies
that became insolvent or under the protection of the insurance departments.
The saving grace for some companies has been policy exchanges. During the late
1980’s, there were a few companies who encouraged 1035 policy exchanges (non taxable exchange) and thousands of policies were exchanged for those giving a higher
interest rate. Some companies used an internal exchange in an effort to save their own
business, while others would actually solicit policies from other companies. Because of
the interest rates at that time, there were many mutual participating policies exchanged
for interest-sensitive products. In many, if not most, cases, there was no requirement
for evidence of insurability. Other companies “streamlined” the evidence requirements.
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Companies that “enhanced” their policies or encouraged exchanging policies for newer
versions, lost some of the profitability that they enjoyed on their old block of business,
but anticipated making up for it by increased profit on their new business because of
higher interest rates and higher profile in the marketplace.
REPLACEMENT QUESTIONNAIRE
In 1993, the American Society of CLU and ChFC (Chartered Life Underwriters and
Chartered Financial Consultants) created an Illustration Questionnaire to assist the
client and the agent under different assumptions used in illustrations. Illustrations are
discussed later in this text, but suffice it to say at this point that a typical method of
replacing policies has been by using illustrations and projections. This questionnaire
asks the insurance company to provide answers for the following questions.

Does what you are showing in this illustration differ from what is going on now
in your company?

Do you treat new policyowners and existing policyowners consistently?

Is the number of deaths assumed in your illustration the same as your company
is currently experiencing?

Does the illustration assume that the number of people dying in the future will
increase, decrease or stay the same as your current experience?

Do the mortality costs generated by your assumptions about the number of
people dying include some expenses or margin for profit?

Do these changes vary by product?

What is the basis for the interest rate used in the illustration?

Is that interest rate net or gross?

Does the interest rate illustrated exceed what you are currently earning?

Do the expense assumptions in the illustration reflect your actual expense
experience?

If more people keep your policies than your illustrations assume, would that
result in all the policyowners getting less?

Do the illustrations include non-guaranteed bonuses after the policy has been
held any specific number of years?
Please note that these are not all of the questions asked, and there can be several
answers to any of the questions.
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States also require that a replacement form be completed and signed by the applican t for
insurance when an insurance policy is being replaced by another policy. The purpose is
to eliminate “twisting” as much as possible.
GR O U P L I FE I N S U R A N C E
Group life insurance is an important part of the life insurance industry, accounting for
about 40% of all life insurance in force by amount with an average certificate of
$32,000.
GROUP INSURANCE REQUIREMENTS
While the minimum size of a group was typically 50 lives a few years ago, it is now
usual for states to require a minimum of 10 lives required by state law and by insurance
companies. The larger the group, the less expense per person is incurred.
Generally, only active, full-time employees are eligible for group coverage, usually
specified by occupation classification of those that must be included in the group, such
as “salaried employees” or “all hourly employees.” The employee must be actively at
work for a normal number of hours per week (usually 30 hours) at the employee’s
regular job at the date the employee becomes eligible for cove rage.
Employees usually have a probationary period, usually one to six months, during which
they are not eligible for coverage. After this period, under a contributory plan (the
employee pays part of the premium) the employee has an eligibility period in which
they must apply for insurance without submitting evidence of insurability. This period
is usually for 30, 31 or 45 days. If the plan is noncontributory, then there is no
eligibility period as all employees automatically go on the plan when they have
completed the probationary period.
The coverage period is usually the length of time that the employee remains with the
employer (assuming the plan stays in force with the employer and the employee pays
their share of the premium, if any). The employer has the right to continue coverage for
an employee temporarily off the job and upon termination; coverage is usually afforded
for 31 days.
Typically, the employee does not specify the benefit amount and the amount is usually
(1) a set amount for all employees, (2) a percentage of the employee’s income with the
employer, (3) an amount that is designated for the position the employee holds (job
title), or (4) a function of the employees length of service. Insurers do not usually write
insurance for less than $2,000 on an employee, most companies require $5,000 or
$10,000, or more. Most companies allow for additional insurance over the normal
maximum with evidence of insurability.
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Employees usually have the option to convert their group life policy into an individual
cash value policy within 31 days after termination of employment or after the employee
ceases to be a member of an eligible position. The death benefit is paid under the group
policy within 31 days after the insured has withdrawn from the e ligible group.
A typical waiver of premium is used with group life insurance plans, and the premium
will be waived as long as the insured can prove disability periodically.
Group life insurance is basically yearly renewable term insurance. Group premiums are
paid monthly, except with some small groups when premiums may be paid quarterly.
Premiums are usually guaranteed for one year only, but often for competitive purposes,
the premiums are guaranteed for a longer period of time.
For contributory plans employee contributions are usually at a set rate per $1,000 of
coverage at all ages. In most states, employers are required to pay at least a portion of
the premium, and some states restrict the amounts that can be paid by any one
employee, commonly 60 cents per month per $1,000 of coverage, or 75% of the total
premium for that employee.
Supplemental life insurance may be provided to employees, normally contributory and
the amounts of insurance available are banded. Generally the maximum is a multipl e of
the employee’s salary.
A common form of group insurance is Credit Life insurance, which provides a benefit
that is equal to the unpaid amount owed to the institution by the consumer. The
creditor, which is usually a bank or a finance company, is bot h the policyowner and
beneficiary of the policy. Premiums are usually paid by the debtor, but if there are
dividends, they are paid to the creditor. Needless to say, group credit life can be very
profitable to the lender and there has been considerable a buse. States have reacted and
most states now have maximum rates that can be charged and most, if not all, states do
not allow the purchase of credit life insurance to be a prerequisite for obtaining a loan.
Group life insurance often includes an accelerated death benefit, which pays a portion
of the face amount of the policy in case of the terminal illness of the employee.
Under U.S. law, the value of the first $50,000 of employer-provided group term life
insurance is non-taxable as income to the employee, but amounts over $50,000 may be
taxable. If the employee contributes towards the plan, then the amount of the
contributions are allocated to the excess coverage. The formula for determining the
taxable amount to an employee is as follows:
1. The total amount of group term life insurance for the employee in each month of the
taxable year.
2. The $50,000 is subtracted from each month’s coverage.
3. The IRS furnishes a Uniform Premium Table and the appropriate rate is applied to
any balance for each month.
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4. Then from the sum of the monthly cost, the total employee contributions for the year
are subtracted.
CONSUMER APPLICATION
Johnson age 45 is provided $150,000 of group term life insurance by his employer.
Johnson contributes $30 per month for this coverage, or 20 cents per $1,000 of
coverage.
Amount of coverage
$150,000
Less:
Exempt amount
50,000
Equals:
Excess over the exempt amount
$100,000
Times: `
Uniform Premium Table rate
x0.15
Tentative monthly taxable income $ 15.00
Times:
Months of coverage
12
Equals:
Tentative yearly taxable income
$ 180.00
Less:
Employee contributions for 12 mos. $ 360.00
Taxable to employee
(-)$ 180.00
Therefore, Johnson had no taxable income for this coverage.
When a group has less than 10 lives, IRS Regulation 1.70-1(c) requires that all full-time
employees who provide adequate evidence of insurability, must be included unless they
“opt” out.
Under the U.S. Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the $ 50,000
tax exemption is not available to key employees if the plans discriminates in their
favor, either in eligibility or type and amount of the benefit; but are not discriminatory
if all benefits to the key employees are also available to all group membe rs. Plans will
not be discriminatory if they have a uniform relationship to the total compensation of
the group members, or the basic rate of compensation of each employee.
For those retired employees, they may be provided group life insurance coverage i f the
plan continues a portion of the term life insurance, or cash -value life insurance is
provided, or a retired lives reserve is established.
Group cash-value life insurance is the simplest method of providing coverage for
retirees, and is usually expressed as either a flat amount or a percentage of the
previous group coverage.
Group paid-up insurance has been popular and is a combination of accumulating
“units” of single-premium whole life and decreasing units of group term life.
Usually this is on a contributory plan and the employees contributions go toward
units of single premium whole life insurance. The employer’s contributions
provides an amount of decreasing term insurance, when added with the amount
the employee pays for, equals the total amount for which the employee is
eligible. Then at retirement, the term insurance portion is discontinued and the
paid-up insurance remains in force on the employee for the remainder of his/her
life.
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Group ordinary insurance can be any traditional plan (except group paid-up)
that provides the cash value life insurance to employees, where the cost of the
term portion is paid by the employer, and the cash value portion is paid by the
employee (which the employee may refuse to accept).
Group Universal Life which has the typical guaranteed interest fate, a fixed
death benefit and loan option, but they also have the flexibility and added returns
of the newer life insurance products. Group Universal Life (UL) is the same as
individual UL, except that Group UL is generally issued (up to a certain amount)
without evidence of insurability and is usually high enough to meet the needs of
most employees. Group UL products usually pay low, or no, commission, plus
administrative charges are lower than individual plans. Generally, these plans
are 100% contributory; therefore the plans are totally portable.
Retired life reserves (RLR) is a group reserve accumulated before retirement in
order to pay premiums on term insurance after retirement. The employer can
make tax-deductible contributions to this reserve on behalf of the employees, and
these contributions are not taxed as income to the employees. RLRs can be
administered through a trust or by a life insurance company and as long as there
are employees participating in the plan, the reserve cannot be recaptured by the
employer. If an employee dies (or resigns) prior to retirement, the individual’s
reserve value is used to fund the RLR for others in the plan. The plan must be
nondiscriminatory and limits the amounts to $50,000.
Supplemental coverages are generally available, either through the insurer of the
group, or by another insurer that offers supplemental benefits. These benefits
can be accidental death, or accidental death & dismemberment.
Some plans also offer Survivor Income Benefits where proceeds are payable in
monthly income benefits only. Beneficiaries are not named but are covered by
specified beneficiaries in the policy, and benefits usually continue as long as
there is a surviving beneficiary and sometimes are discontinued if the survivor
remarries.
Dependent Life insurance may be offered whereby the spouse and/or unmarried
dependent children are insured for usually a small amount of life insurance.
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STUDY QUESTIONS
Chapter 4
1.
2.
3.
4.
5.
Term Life Insurance
A.
builds cash values each year.
B.
is the simplest form of life insurance.
C.
cannot be renewed.
Life insurance companies change
A.
more for smokers.
B.
more for “preferred” risks than “sub-standard risks”.
C.
the same premium for smokers and non-smokers.
One of the primary uses of decreasing term life insurance is for
A.
life insurance during the working years of the insured.
B.
mortgage insurance.
C.
family income.
A whole life insurance policy
A.
pays a death benefit upon the death of the insured, regardless of when that might
be.
B.
must be paid in a lump sum upon the death of the insured.
C.
can be voided by the insurance company if the insured become sick.
With a Limited Payment Whole Life policy
A.
the premium payment is limited to a lump sum.
B.
the insurance company is limited to paying the insured only if there is an
accidental death.
C.
the policy remains in full force for the “whole of life” but premiums are paid for a
limited period of time only.
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6.
7.
8.
9.
10.
11.
12.
A Modified Life insurance policy
A.
is a Term Life Insurance policy.
B.
is a Whole Life policy with early premiums lower than typical Whole Life
policies.
C.
premiums remain level throughout the life of the insured.
Debit insurance
A.
is usually written in amount of $100,000 and higher.
B.
premiums are low.
C.
is now sold by “home service life insurance companies”.
Juvenile Insurance is a Whole Life policy
A.
principally used for guaranteeing a college fund.
B.
sold to teenagers.
C.
whereby the insured must prove insurability.
Group life insurance
A.
is generally available to all employees.
B.
usually has a probationary period before an employee is eligible for coverage.
C.
is basically a Whole Life insurance policy.
Employer-provided group Term Life insurance
A.
is non-taxable to the employee if the value is under $50,000.
B.
requires the employee to prove insurability.
C.
covers the employee even if they leave their employment.
An Enhanced Life policy
A.
has low premiums at the beginning of the policy and then they increase.
B.
is a team policy without cash values.
C.
uses dividends to reduce the premiums.
Burial insurance
A.
can only be used to cover the funeral director’s services.
B.
is usually sold by the funeral director who is also an insurance agent.
C.
is usually sold to college age individuals.
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13.
14.
15.
The “Replacement Questionnaire” was created to stop
A.
“twisting”.
B.
“redlining”.
C.
an agent from replacing one life insurance policy with a better one.
With a Credit Life insurance policy
A.
the insured is the beneficiary.
B.
the bank or lending institution is both the policyowner and beneficiary of the
policy.
C.
the bank or lending institution pays the premiums.
Whole Life insurance pays a death benefit
A.
regardless of when the insured dies.
B.
only if the insured dies within a certain period of time, example: tens year.
C.
if the insured losses their sight.
Answers to Chapter Four Study Questions
1B 2A 3B 4A 5C 6B 7C 8A 9B
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10A
11C
12B
13A
14B
15A
CHAPTER FIVE - INTEREST SENSITIVE LIFE INSUR ANCE
This chapter could just as easily be called “new products”, as interest sensitive products
are relatively new. As used in this text, interest sensitive life insur ance (there are also
interest-sensitive annuities, such as equity indexed annuities) is a newer generation of
life insurance policies that are credited with interest currently being earned by
insurance companies on these policies.
V A R I A B L E L I FE I N S U R A N C E
Variable Life Insurance is an investment-oriented whole life insurance policy that
provides a return linked to an underlying portfolio of securities.
The portfolio typically is a group of mutual funds established by the insurer as a
separate account, with the policyowner given some investment discretion in choosing
the mix of assets among such investment vehicles as common stock fund, bond fund,
&/or a money market fund. Variable life insurance offers fixed premiums and a
minimum death benefit. The better the total return on the investment portfolio, the
higher the death benefit or surrender value of the variable life insurance policy.
Variable life insurance (VLI) was first offered in the U.S. in 1976 with only limited
success. Equitable Life Assurance Society was a pioneer in VLI in the U.S., and
suffered through four years of discussion, development and negotiations with the
Securities and Exchange Commission (SEC) before the product was approved. Four
years later, John Hancock, followed by Monarch Life, offered VLI products. Today,
many insurers offer some versions of this policy.
VLI was “invented” primarily to offset the effects of inflation and high interest rates on
life insurance. Historically, the stock market tends to increase (when it do es increase) at
a rate higher than inflation; therefore these plans should provide an excellent hedge
against inflation. However, for short term investment results, sometimes inflation goes
one way and the performance of investments goes the other.
VLI has been slow to develop for several reasons, including the following:

The policy must be registered as a security under the Securities Act of 1933.

The agent selling it, therefore, must be registered under the SEC Act of 1934,
and must pass the National Association of Security Dealers (NASD) Series Six
Examination to have a license to sell it.

Many agents have been uncomfortable selling securities, having been used to
products with guarantees.
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The National Association of Security Dealers (NASD) Conduct Rul es, by which any
licensed representatives – including those who sell variable insurance products –; cover
a very wide range of subjects. However any person who sells variable products needs
to be familiar with these rules. There are the following nine to pics covered by these
rules. A summary of the contents of these rules describes the topic.
2100 General Standards: This topic defines the established standards of marketing
securities and is illustrated by a number of “Don’t Do” examples. Unethical pra ctices
are described, including withholding, trading ahead, front running and intimidation.
2200 Communications with Customers and the Public: Details the proper methods of
ethical communications and how to achieve full disclosure. Discussed the proper ways
to use rankings, confirmations, forward materials and disclose financial conditions.
2300 Transactions With Customers: Discusses “suitability” – recommending certain
products for specific situations and needs and goals of the clients. Also provides
directions as to how to deal with customers.
2400 Commissions, Markups and Charges:. This topic discusses discounting of
securities (must not), the differences between members and nonmembers, and a
discussion of charging for services rendered.
2500 Special Accounts: Handling of discretionary accounts and margin requirements
by broker-dealers.
2700 Securities Distribution: Very broad discussion of underwriting terms, conflicts of
interest, securities taken in trade, transactions with related persons a nd price disclosure
in selling agreements.
2800 Special Products: Rules on direct participation programs, variable contracts,
investment company securities, warrants, and options, including index options.
2900 Responsibilities to Other Brokers or Dealers: When a member of the Association
has a financial interest in the business of another member, under what circumstances do
they provide financial disclosure to the other member, and to what extent.
3000 Responsibilities Relating to Associated Persons, Employees and Other’s
Employees: The supervision of Registered Representatives, surely bonds, etc.
NOTE: These topics are discussed in more detail in the section on Variable Universal
Life.
In December 1976, the SEC introduced Rule 6E-2 which provided some exceptions
from the Investment Company Act of 1940 that provided impetus for this product’s
acceptance. This rule requires that insurance companies provide an accounting to
contract holders, imposes limitations on sales charges, and required that insu rers offer
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refunds of exchanges to variable-life purchasers under certain circumstances.
Policyowners must also be given the opportunity of returning to a whole -life policy.
The principal part of Rule 6E-2 is that it defines VLI as a policy in which the insurance
element is predominant. Cash values are funded by separate accounts of a life insurer
(not mingled with other funds held by the company). Perhaps more importantly, the
death benefits and cash value vary to reflect the investment experience. Bu t the policy
has to have a minimum, guaranteed, death benefit, and the mortality and expense risks
are borne by the insurer.
The policy itself is structured like a whole life policy inasmuch as there is a stated face
amount at a stated age, and this face amount requires stated level premium amount. The
“variable” element is the cash value, and it rises and falls depending upon the
investment results of the investment fund pertaining to that particular VLI policy.
There is no guaranteed minimum for the funds, however the fixed premium VLI policies
guarantee that the face amount will not go below the face amount shown on the policy
at time of issue, and the level premium is required to keep the policy in force.
While the original VLI policies had only a money market account and a common stock
available for the investment vehicles, there are more choices today. If the investment
account(s) are positive, then the face amount of the policy is adjusted upward at the
anniversary date. However, if the account(s) are negative, the death benefit will
decrease but never less than the face amount stated on the policy.
Investment results of a VLI policy is affected by borrowing. If a policy loan is taken,
the equity of the underlying investment accounts is collat eralized and the insurance
company moves an account which is equal to the borrowed amount, from the investment
account to a “loan guarantee account” which is not subject to market fluctuations. The
fund will earn less (usually 1% or 2%) than the interest charged the policyowner on the
loan. This loan guarantee account will contain these funds until the loan is repaid.
VLI provides against “inflation” by guaranteeing that the face amount of the policy will
never be less than the stated face amount on the policy, regardless of the fluctuations of
the investment account, as long as the premiums are paid.
 The face amount guarantee of the Variable Life policy is not available in Universal
Life or Universal Variable Life.
MARKET SHARE OF VLI
Prior to 1998, only 3 companies sold VLI products and represented only 1% of the life
insurance sold. By 1981, there were 10 companies selling VLI and market share
increased to 2.5% of the ordinary life premium. Even though the growth of VLI was
inhibited by large development costs to the insurance companies, and in particular the
licensing requirements for agents and their discomfort with mutual funds products
79
(many agents felt disloyal to the life insurance industry by marketing securities
products), VLI products accounted for 6% of the market in 1991, and approximately
15% in 1993. The Equitable reported that it has a historical net rate of return on its
common stock account of over 14% per year for the over 20 years it has marketed VLI
products.
ADVANTAGE OF VLI
The key advantage of VLI is that the contract holder has the ability to direct his/her
account value to the investment that they choose, limited only by the number of
investment accounts. While VLI started with just two investment choices, they now
have many choices, such as aggressive stock account, balanced funds, global funds,
bond funds, high-yield bond funds, guaranteed interest accounts, zero-coupon accounts
and real estate investment accounts.
VLI has suffered higher expenses with the first types of VLI offered, however they have
offered the highest net return available from a life insurance policy from 1976 to 1994
when invested in common stock funds
The policy must be sold with a prospectus which divulges more information to the
prospective purchaser than provided by other traditional insurance policies or by
companies marketing traditional products.
When VLI operates correctly, the policyowner will have life insurance protection, a
“family” of mutual funds for investment purposes, and the abili ty to direct the
investments within those funds, and there is no income tax liability as funds are moved
within the contract. The policy shelters interest, dividends and capital gains from
current income taxation. Plus:
 The sale of one fund and purchase of another within the contract is not a taxable
event.
The principal disadvantage to many people of the VLI is that once the VLI has been
purchased, the policyowner may not increase or decrease the premium, as it is des igned
be a level premium policy. Conversely, this can be an advantage as it is a method of
“forced savings” and many people who purchase universal life policies with the flexible
premium frequently use the flexibility as an excuse not to invest, with laps es as a result.
The amount of life insurance is fixed at its minimum level as of the date of the purchase
of the policy. If a policy lapses it may be reinstated as with other life insurance
policies, with one exception: past-due premiums collected must not be less than 110%
of the increase in cash value which is then immediately available after reinstatement.
This is necessary as the reinstated policy contains values that assumed the policy had
never lapsed, so the additional premium would reflect an in crease in the investment
account during the lapse period.
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Policy loans are available for the amount which equals 75% or more of the cash value at
a stated interest or variable interest, rate.
VLI policies are riskier to the policyowners than the traditio nal life insurance policies,
and therefore are subject to more laws, rules and regulations and require more
disclosure to the policyowner. If a person’s financial planning program is built around
a highly liquid and still nearly risk-free plan, VLI is a poor substitute to traditional life
insurance.
U N I V E R S A L L I FE
Historically, Universal Life (UL) was first mentioned as a concept in 1946 and then
later in 1964 in actuarial articles in industry publications. Regardless of its actuarial
origin, the first published concept of the modern UL was presented at a conference in
1975. The following year, a small company in Atlanta offered the first UL policy, but
because of adverse tax problems, it discontinued sales. In 1979, E.F. Hutton Life (then
Life of California) offered UL, and while it was welcomed with open arms by many,
others loudly and continually voiced opinions that it was (1) bad for the companies
because it made them into nothing but “banks,” (2) it was not good for the consumers as
it was too difficult to understand, plus a multitude of other reasons, and (3) it was not
good for the agent as the commissions were going to be lower and they were going to
have to be under dual regulation (insurance and SEC).
As they say, “timing is everything.” During the early 1980’s interest rates on
newly invested funds were higher, much higher in many cases that those earned
on established investment portfolios. This gave UL a head -start on the
traditional cash-value products with their interest rates of 3 –3 ½ %. However,
what goes up, must come down, and when interest rates declined, so did the
popularity of UL.
Universal Life policies offer flexibility: flexible premium payments and
adjustable death benefits. After the first (minimum) payment, the polic yowner
can pay whatever they wish into the policy, and at whatever time they wish, and
in some cases, can skip paying altogether if the cash value can cover the
premium charges. And to top it all off, the policyowner can adjust the death
benefit with very little difficulty (with one caveat: if the death benefit increases,
the insurer may ask for evidence of insurability).
As happens so frequently, companies geared up for the expected bonanza of
increased sales and premium income. But, again typically, many companies
believed that since this product “sold it” and there was so much administrative
cost (many projections and other required consumer information) that the agents
should be able to live with lower commissions, especially since they would be
selling so many policies.
81
The agents did not share the production hysteria of so many companies at that time and
commissions were not dropped as much as the companies expected. Administrative
expenses were higher than anticipated by many companies.
As mentioned earlier in this text, UL policies are “transparent” since the
policyowner can see exactly how the funds are distributed. They are furnished
with many illustrations and examples of the fund distribution and expected
returns, and while the policyowner cannot evaluate the adequacy of many of the
assumptions, they certainly can see where the money goes.
 The principal difference between the CAWL and UL is that UL polices have
neither fixed premiums nor fixed death benefits.
The movement of funds in UL follows the following schedule (Note that the term
“policy period” is used, instead of typical mode of payments, such as monthly,
quarter, annual, etc. The reason is that this is a flexible contract and the
premium paying period does not have to be a predetermined time period):
 The policyowner pays a minimum premium to the company.
 The company subtracts expense charges for the first policy period. (This is
called “front-end loading” and some UL policies do not have this charge at
this time.)
 The company then subtracts the mortality charge on the insured’s age and the
policy’s net amount at risk. Premiums for any supplemental benefits
(Accidental Death, etc.) are also subtracted.
 The remaining amount is the initial cash value of the policy.
 The cash value is credited with interest, which then becomes the end-ofperiod cash value.
 UL policies generally have high surrender charges. The cash value less the
charge is the cash surrender value.
 The second policy period (usually this is a month) starts with t he previous
cash value. The policyowner may (or may not) add additional premium at
this time. If the previous period’s cash value is sufficient to cover the
mortality and expenses charges (current) then no premium is necessary.
However, if it is not sufficient, the policy lapses unless additional premiums
are paid.
 For the second policy period, the cash value at the end of the first period is
increased by any premium payment, and then reduced by the expense and
mortality charge, increased again by interest at the current rate.
This process continues until the policy lapses or surrenders.
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DEATH BENEFITS
An Adjustable Death Benefit
When traditional types of life insurance are written with a certain death benefit (such as
$100,000)-that face amount of the policy remains in effect as long as the policyowner
pays the premium, but if no premium is paid, the insurance can terminate. One
important feature of universal life policies is that the death benefit is adjustable -it could
be $100,000 at the beginning of the policy period, but it might drop down to $50,000 at
some point and later rise to $175,000. Within certain limitations, the policyowner
controls these adjustments.
With this adjustment feature, no new policy is needed to reflect the different amount of
insurance; the adjustments are made to the existing policy. When the policyowner
increases the death benefit, some insurers require proof that the insured person is still
insurable-in good enough health to meet the insurer's standards.
Death Benefit Op ti ons:
At the onset of a universal life policy, the policyowner chooses one of two death benefit
options:
OPTION A
The first choice, Option A, provides a level death benefit similar to traditional life
insurance policies. This level benefit is stated in the policy, but the insured still has the
option to increase it or decrease it during the policy period.
When the death benefit is selected, the premium is determined, with part of it destined
to pay for the insurance coverage (the death benefit) and p art to be deposited into the
cash value account to earn interest. The policyowner pays this same premium regardless
of whether the death benefit is increased or decreased during the policy period. (An
exception is when the policyowner exercises the premium -paying flexibility of
universal life, discussed later.) Thus, the policy provides a level death benefit and a
cash value account that accumulates interest.
It is important to differentiate between the death benefit -the insurance protection-and
the cash value. For a universal life policy to receive the special Internal Revenue Code
(IRC) tax considerations that apply to insurance policies, there must always be an
amount at risk until the insured reaches age 95. (To reiterate, the amount at risk refers
to the amount for which the insurer is at risk, and is the difference between the face
amount [death benefit] of the policy and its cash value. If a policy with a $100,000
death benefit had cash values of $20,000, the amount at risk would be $80,000.)
As the policyowner continues to pay premiums, the cash value increases while the
amount at risk for the insurer decreases. In times when earnings are high, it would be
possible for the cash value and the amount at risk to be nearly the same.
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If the cash value begins to approach the amount of insurance, the death benefit must be
raised. The Internal Revenue Code dictates a certain minimum amount at risk that must
be maintained in order for the policy to continue to be treated as life insurance and not
as an "investment.” This minimum amount is often referred to as the tax corridor or the
risk corridor.
OPTION B
The second death benefit choice, Option B, provides for an ever -increasing death
benefit that is made up not only of the amount of insurance, but also the amount of the
cash value account. For example, if the original death benefit (at the onset of the
policy) is $100,000 and the cash value is $45,000; when the insured dies, the
beneficiary of the policy will receive a $145,000 death benefit.
The insured's death at any point results in a death benefit equal to the $100,000
insurance (on this example policy) plus whatever the cash value is at the time of death.
Because it is known from the beginning that the death benefit will increase, the
premiums for Option B would be greater than for Option A so as to pay for the
increasing amount of insurance protection. An individual could choose to pay the same
premium for an Option B type of policy as for an Option A type policy, but the cash
values would grow at a reduced rate.
THE CASH VALUE ACCOUNT
CHARGES TO THE ACCOUNT
The Insurance Premium: Of each premium paid, a portion pays for the life insurance
protection. This amount, based upon mortality rates for the particular individual, is
typically taken as an adjustment to the cash value account once a month. Then, as
previously discussed, another portion goes to the cash value account to draw interest.
Loading: Not all of the remaining payment draws interest, however, because sales and
administrative expenses must be paid. This charge is called a “load” or “loading.”
Expenses may be deducted as front-end loads or back-end loads. In a front-end loaded
policy, the insurer deducts a certain percentage from each premium payment before
crediting it to the cash value account as discussed above. If the load is 6%, and the
premium payment is $1,000, $60 would be deducted, leaving $940 for the cash value
account.
84
Recent universal life policies are more often back -end loaded, which means the entire
premium payment is deposited into the cash value account. The back -end loading
comes into play if and when the policyowner performs certain transactions in the cash
value account, such as surrendering the policy for its cash value. The advantage of
back-end loaded policies is that the cash value account has more money to earn interest
in the early years. The disadvantage is that some back -end loads are quite high.
Some insurers offer the equivalent of a no-load arrangement, whereby the insurance
company takes a percentage of current earnings, similar to no -load mutual funds.
Other Charges: Insurers may also charge a flat fee to cover the cost of maintaining and
servicing the policy. This may be an annual fee or a monthly fee. Some insurers have
first year charges that apply in addition to all other policy charges. After the first year
the policy is in force, these charges no longer apply. As examples, first year charges
may be:



Up to one dollar per thousand dollars of insurance coverage.
No excess interest paid on the first $1,000 cash value, which in effect is a
charge because that interest is lost to the policyowner.
A flat monthly fee paid in addition to any other policy charges.
Insurers provide the universal life policyowner with an annual stateme nt that shows
exactly what transactions occurred and what charges were assessed during the year.
SINGLE PREMIUM UNIVERSAL LIFE
Like whole life policies, universal life insurance may be purchased with a single
premium paid at the policy's inception. The benefits of paying a single large premium
are the same as those for whole life and could be magnified as the result of the current
interest rate paid on universal life cash values. Of course, all of the cautions about
maintaining the risk corridor in a universal life policy must be observed.
THE ADJUSTABLE PREMIUM
Most universal life policies are purchased not with a single premium, but with periodic
payments spread over a number of years. At the risk of being repetitive, it is important
to remember that whereas traditional life insurance policies have a fixed level premium;
payable on a regular schedule, universal life offers an adjustable or flexible premium.
This feature permits the policyowner to raise, lower and even skip premiums. However,
lowering or skipping premiums is possible only if enough cash value has accumulated
to pay for the pure insurance costs and any administrative charges. If the cash value is
not adequate, a payment must be made to keep the insurance in force.
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THE IMPORTANCE OF PREMIUM FLEXIBILITY
When a universal life policy goes into effect, a minimum level premium payment is
established. For the policy to have any cash value, obviously, some premiums must be
paid. As stated earlier, once the cash value grows adequately, thi s amount can be used
to keep the insurance protection in force whether or not the policyowner pays additional
premiums.
As an illustration of the importance of flexible premiums, assume an individual
purchased a universal life policy with a death benefit of $200,000 with an annual
premium of $1,000 and several years later, the cash value grew to $15,000 . At this
point, the policy owner’s first child enters college and the policyowner wants to skip
the annual premium on the policy. The policyowner can do so because there is
adequate cash value to pay for the insurance protection. (See the illustration on the
next page.)
The policyowner could continue to skip payments for several years while the cash value
account takes care of the insurance protection, or the policyowner could make reduced
premium payments. Of course, at some point, the cash value used to pay for the
insurance protection could dwindle to the point that no additional funds would be
available for insurance protection. At that point, the policyowner must make a payment
or the insurance lapses-there is no more coverage. In addition, since the cash value
account was reduced during the years, no premium payments are made; the policyowner
could not rely upon those funds to be available for other purposes.
INCREASING THE PREMIUM PAYMENT
If the insured’s financial condition, in the above example improves, and the
policyowner wants to rebuild the cash value account. Although the original insurance
(minimum) premium was $1,000, the policyowner elects to pay $1,500 annually. By
increasing the premium payments, the policyowner benefits because the cost of
insurance protection remains the same, as the additional paid premium goes to the cash
value account to earn interest (Assuming they have not increased the death benefit.)
But remember, the so-called risk corridor-the IRS-dictated minimum of insurance
protection to cash value-must be maintained in order for the cash value account to
continue receiving favorable tax treatment. At any time, the policyowner can revert to
the original premium payment amount or again stop paying premiums entirely.
An Illustration of Adjustable Premium and Death Benefit illustrates one of many ways a
universal life policyowner could adjust the premium and the death benefit over many
years. Notice each adjustment can be made independent of the other; that is; the
premium can be changed without affecting a death benefit and vice versa, as long as the
cash value account is adequate to make the desired adjustment. A s ummary of the
transactions follows the illustration.
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At age 30, the insured purchases a universal life death benefit of $100,000 for a
$500 annual premium. This coincides with the birth of a child. At $500 per year,
the cash value grows moderately. When the insured is age 33, the policyowner
receives a $1,000 windfall, which is deposited into the cash value account with the
usual premium. At age 36 the policyowner withdraws $500, but continues to make
level $500 payments and the death benefit remains at $100,000.
At age 40, the insured increases the death benefit to $150,000 and begins making
$900 premium payments. At age 42, the insured skips one premium payment, then
resumes paying at age 43. At age 44, the policyowner increases the premium
payment to $1,500 per year, retaining the $150,000 death benefit.
At the insured's age 48, the child enters college. The insured withdraws $4,000 that
year and the next year, while continuing premium payments. At ages 50 and 51, the
policyowner withdraws $4,500 each year. At 52, after the child graduates from
college the insured continues paying premiums and keeps the $150,000 death
benefit, making no further withdrawals. At age 55, the insured lowers the premium
payment in anticipation of retirement and drops the death benefit to $100,000. At
age 60, the insured makes no more premium payments, and lowers the death benefit
to $50,000. At that time, the cash value is sufficient so that no further premiums are
required.
USES FOR THE CASH VALUE ACCOUNT
Withdrawals: Universal life policyowners are permitted to make withdrawals from the
cash value account. Withdrawals of only a portion of the cash value (rather than all of
it) are sometimes called partial surrenders because the policyowner is surrendering or
giving up part of the policy. The withdrawal is made from the cash value account, so
that portion of the cash value is surrendered. Most universal life policies also reduce
the death benefit by the amount of the withdrawal.
Withdrawal Charges: While this illustration shows the cash value account reduced
to $3,000, in reality it would be reduced even more because of fees charged for the
withdrawal. When a policy is back-end loaded, this is one of the situations where
the expense loading applies. Front-end loaded and no-load policies are also likely to
assess a charge for withdrawals.
Taxation on Withdrawals: Policyowners who make partial withdrawals from cash
value accounts may or may not have to pay taxes on the withdrawal, depending upon
the circumstances. For policies at least 15 years old, the portion withdrawn is not
taxed unless it is greater than the amount the policyowner has put into the policy.
87
For example, if premiums paid total $20,000 and the policyowner takes out $20,000,
there is no tax due since $20,000 represents a return of capital on which the
policyowner has already paid taxes. If the same policyowner withdraws $21,000,
however, taxes are due on the $1,000, which is considered interest.
Policies that have not yet been in force 15 years when a partial withdrawal is made,
are subject to more complex rules dealing with the specific age of the policy, how
much has been paid into the policy and the amount of the withdrawal.
Paying and Receiving Interest: Because a withdrawal is not the same as a loan, the
amount withdrawn does not have to be repaid, nor is any interest charged the
policyowner for using the withdrawn sum. From the insurance company's
viewpoint, withdrawal is simply a return of the policy owner’s money. Since the
money is no longer in the policy's cash value account; no interest is earned on the
amount withdrawn.
Repaying Partial Withdrawal:
The policyowner is permitted to return the amount withdrawn to the universal life
cash value, but repayment does not restore the death benefit to its original level.
The insurance company might permit the policyowner to restore the original death
benefit, but usually will require proof that the insured is still in good health and
insurable.
In addition, whether or not the death benefit is restored, repayment of the
withdrawal is considered to be a premium payment and is subject to whatever the
insurer normally charges.
Costs of Withdrawing and Repaying
At first glance, partial withdrawals from a universal life policy might seem im mensely
preferable to borrowing money-whether from an outside lending institution or from the
policy itself-since no interest is charged and the policyowner can return the money to
the policy later. However, careful consideration should be given to the ac tual costs of a
withdrawal that will be repaid to the cash value account:
• Fee paid to the insurer at withdrawal.
• Reduction of the death benefit (cost to the survivors).
• Loss of interest on the money while withdrawn.
• Charges assessed by the insurer when the amount is returned to the cash value
account.
Even apart from the reduction in the death benefit, the other costs can be considerably
higher in the long run than a loan.
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CONSUMER APPLICATION
About 10 years ago (when interest rates were higher), Jerome wanted to borrow $10,000
for the down payment on a new SUV and he did not want to use the auto dealers finance
company as they charged 10% interest. He learned that he could borrow $10,000 from
his Universal Life policy with only a surrender charge of $25. Jerome thought that was
indeed a great deal!
However, when he talked to his insurance agent about the procedures to get the money,
the agent suggested he may want to reconsider. His “current interest rate” (at that time
was 10%), so he would lose the 10% interest on the money that he would withdraw.
When Jerome wanted to repay the $10,000, the front-end load would be 7% ($700).
Since he would lose the 10% on the investment he would have received, and paid the
loading of $700, his loan would actually cost him 17%.
While the 10% (coincidentally for illustration purposes) he loses on his investment
would wash with the 10% the finance company would charge, if he should die during
the loan period, the amount of the loan would be subtracted from the death benefit.
Comparing the other costs ($25 vs. $700) leads Jerome to look for other financing.
In many cases, it will, indeed, be worthwhile from the policy owner’s point of view to
make partial withdrawals. But policyowners need to be well informed about the cost of
this decision.
Total Withdrawals
Universal life policyowners also may withdraw all of the cash value. However, as
stated earlier, payment for the insurance protection is periodically taken from the cash
value account. If the entire amount is withdrawn, no money is available to continue the
insurance coverage. Therefore, the policyowner must make another premium payment
to keep the insurance in force. Insurers are required to notify policyowners if the
insurance protection becomes endangered.
Some insurers charge a penalty if the policyowner removes all of the cash values in the
early years of the policy. This typically involves taking back all or part of the excess
interest earned during the previous 12 months.
Poli cy Loan s
Like other cash value life insurance, UL policies allow policy loans up to the cash value
amount. Unlike a withdrawal, a loan is expected to be paid back and the policyowner
pays interest, typically at a low rate relative to interest rates in the market place. While
fixed interest rates are common, some insurers offer loans at variable rates, just as other
lenders. The rates to be charged are printed in the policy.
For cash values in the account that are drawing interest, insurers sometimes pay a lo wer
rate on the amount borrowed against than on the amount not borrowed. For example,
assume there is $10,000 in the cash value account. The policyowner borrows $6,000.
The insurer might pay only its guarantee interest rate of 4% on the $6,000 borrowed,
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but continue paying the current interest rate (guaranteed interest rate plus excess rate)
of 8% on the remaining $4,000.
Other insurers may treat a UL loan as a so-called wash loan because the interest rate the
borrower pays and the interest rate the insurer pays on the cash value are the same, so
each rate "washes out" or equalizes the other.
For example suppose the current rate the insurer is paying on the cash value account is
7% and the policy loan rate 6%. With a wash loan, the 7% rate would be red uced to 6%
to match the loan rate.
V A R I A B L E U N I V E R S A L L I FE
Variable Universal Life (VUL) is discussed in a little more detail than other types of
policies because it is the most versatile of the life insurance products and is very
popular. VUL is a policy that has the premium flexibility and policy adjustment
features of universal life with the investment options of variable life, which helps to
explain why this policy is so popular.
From the viewpoint of a “contract,” a VUL policy is Universal Life as f lexible
premiums, death benefit options (A and B) and the other standard provisions of a UL
policy are present in a VUL policy. There is really only one big difference, and that is
that of the variable nature of the account value of the policy. UL accoun t values are
gathered in the insurance company’s general account and then credited with a
guaranteed rate of return, or a higher value if justified by the interest rates of the
insurer. VUL policyowners can place their cash value in any of a wide variety of
separate accounts or subaccounts – including a fixed interest guarantee from the
company’s general account. (At this point there would be no difference between a VUL
and a UL policy, except that they could later change the investment option to a separa te
account.) The accounting for the separate account unit value is the same as with
variable life.
FEATURES OF THE VARIABLE UNIVERSAL LIFE POLICY
Even though the features and the benefits are the same as with UL policies, with the
flexibility of VLI in premiums, since it is now a “mixture” of the two policies, various
features and benefits should be considered.
As with any whole life plan, VUL policies provide lifetime insurance protection.
 For tax purposes, VUL is a type of life insurance, therefore net premiums goes into
separate accounts where they earn a current rate of return, and earning accumulates
on the same tax-advantaged basis as cash values of more traditional whole life
policies. Note, however, that if the death benefit is to be increased, the policyowner
can pay additional premiums, but if the amount is above a certain amount, evidence
of insurability may be required or the policy may become a modified endowment
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contract and lose its tax-advantaged basis. (A discussion of modified endowment
contracts [MECs] appears after the discussion of features.)
 Separate accounts are accounts into which the policy owner’s funds are invested and
are called “separate” because they are separate from the company’s funds. These
funds earn a variable return. As with mutual funds, these funds provide returns or
losses based upon the performance of the separate accounts, and they are NOT
guaranteed by the insurer and the returns on the separate accounts are NOT
guaranteed.
 Policyowners can transfer funds from one account to other accounts, and to do so
without charge. The number of transfers is established by the contract, and usually
is between 4 and 12 a year.
 VUL policies offer a multitude of account choices, often 10 or more, including a
wide variety of stock accounts, multiple bond funds, managed funds and asset
allocation funds.
 The cash value in a VUL policy is constructed of premiums paid, less fees charged,
less periodic deductions for the cost of insurance, plus (or minus) returns generated
by the individual policy owner’s accounts. Obviously, cash values are not
guaranteed by the insurer and neither the insurer or the policyowner (or the agent)
can accurately predict future earnings.
 Death benefits are the same as with Universal Life – Option A or Option B. While
the insurers do not guarantee death benefits, many of the newer policies offer some
protection against falling death benefits; some guarantee the death benefit to age 65.
Other companies offer guaranteed death benefit riders (with an addi tional, but quite
modest, charge), and this will guarantee that the policy will remain in force even if
the cash value is zero.
 The expenses and charges of a VUL are “transparent” (or “unbundled” as some say)
and take many forms. Most VUL policies have a system whereby deductions are
taken from premiums as paid, and these deductions cover marketing costs, premium
taxes and other expenses. First year deductions are shown to cover the marketing
costs, which are accumulated the first year. Deductions are gu aranteed not to
exceed an amount stated in the policy, but can be lower. VUL has a reputation of
having high expenses charges when compared to UL or VLI and traditional policies,
but recently policy expenses have decreased so it is more “cost -efficient.”
 A policyowner must be given a prospectus (and a buyers guide in many states) at
some stage while the policy is being discussed with the prospective policyowner.
The prospectus contains the specifics of the policy and the separate investment
accounts and fees to be charged. The policyowner also receives an annual report,
which provides the latest status of all policy transactions, including cash values and
deductions.
 The VUL policy form contains most of the standard provisions and options available
under traditional insurance policies, such as grace period, settlement options, policy
loans, etc.
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STANDARD PROVISIONS
While most of the standard provisions of the VUL are the same as those of other life
insurance policies, there are three provisions that differ, two that are unique to VUL,
and certain riders are available.
Grace Period
Since the VUL is an “unbundled” policy, there really is no connection between the
payment of the premium and the continuation of the coverage, but whether the policy
continues is a function of the cash value. If the cash value is insufficient to maintain
the cost of insurance, the policyowner will be so notified that a premium must be paid.
From that date – date of notification – the required premium to keep the policy in force
must be paid within 61 days or the policy will lapse. Full coverage remains in force
during the 61 days.
Reinstatement
If a VUL policy should lapse, it may be reinstated at any time within a stated period of
time (usually 2 years), subject to specified requirements and conditions:
 An application for reinstatement must be sent to the company, signed by the
policyowner.
 The policy must not have been totally surrendered; i.e. it must not have been
surrendered for its net cash surrender value.
 The company may require evidence of insurability, and if so, it must be provided to
the company.
 Premiums which, with interest, are sufficient to keep the policy in force for a
stipulated period of time (3 months usually).
Free-Look Provision
As required by law, after the policy is issued, the policyowner has a stipulated period of
time (usually 10 days after receipt of the policy by the policyowner, or 45 days after the
application has been signed) to return the policy to the insurer and receive a full refund
of all premiums paid, no questions asked. In some states, the refund will reflect
earnings or losses in the cash value accounts, due to investment(s) performance, for the
period of time that the money was in the control of the insurer.
Conversion Privilege
Unique to VUL policies, the VUL allows policyowners to exchange the VUL for a
comparable non-variable plan, or they may transfer all values in the subaccounts of the
VUL to the general and fixed account within 24 months after issue of the VUL. The
new policy, if the VUL is exchanged, will have the same effective date, same issue age
and the same underwriting classification as the VUL.
Annual Report
At the time the policy is issued, it is impossible to project what the cash values will
actually be because of the fluctuations of the investment accounts. The SEC also
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requires “full-disclosure,” so for these reasons, the policyowner is sent an annual report
that explains the current status of the policy, in full detail. The annual report will
contain the following information:
 death benefit;
 total cash value, by account and by percentage allocated to each account;
 net cash surrender value;
 total premiums that were paid since the previous report;
 policy loans and interest charged on loans made during the previous ye ar, if any;
 partial surrenders made since the last report; and
 the transfers of funds among the accounts
Semiannual reports are also sent to the policyowner, which show the 6 -month
performance of the cash value accounts in which the funds of the policyown er has
invested and a complete listing of all investments in the policy.
Riders & Options Available
The same options that are available for Universal Life and some traditional products are
generally available for VUL policies. Following is a list of thos e that may be included:
 Waiver of Premium in case of disability;
 Cost of Living Riders (COLA) which may be either a rider or part of the policy and
may or may not have a separate premium;
 Accidental Death Benefit;
 Accelerated Death Benefit;
 Term insurance rider;
 Family Insurance rider; and
 Guaranteed Insurability Rider (GIR), or option, which allows the increasing of the
specified amount on each option date, without evidence of insurability and at
standard rates.
MODIFIED ENDOWMENT CONTRACTS
Congress enacted the Technical and Miscellaneous Revenue Act of 1988, commonly
referred to as “TAMRA,” and which revised the definition of a “life insurance contract”
for tax purposes. One of the principal purposes of this act was to discourage the sale
and purchase of life insurance for investment purposes or as a tax shelter, and by doing
so; they created a new class of insurance, known as modified endowment contracts or
MECs.
93
Life insurance has traditionally had a very favorable tax treatment, but if the policies d o
not meet the qualifications set forth in TAMRA, then the policyowners will not receive
this favorable tax treatment.
Basically, if the policyowner makes a loan or withdrawal from the policy, the amount
that is loaned or withdrawn will be taxed first as ordinary income and then as return of
premium – if there is a gain of more than premiums paid. In addition, there is a 10%
penalty tax imposed on this amount if the policyowner is less than 59 ½ years old.
So as not to be classified as an MEC, the policy must meet the “7-pay test” (discussed
in detail later). Briefly, this states that if the total amount paid into a life insurance
contract by the policyowner during its early years, exceeds the sum of the net level
premiums that would have been payable to provide paid-up future benefits in seven
years, then the policy is an MEC – and it can be an MEC at any time during the first 7
years – and it will remain an MEC during the duration of the policy.
Sound complicated? It is! Therefore, the determination as to whether a policy is an
MEC is the responsibility of the insurance company and its actuaries.
The potential for abuse or misuse particularly exists with single -pay life insurance
policies, limited pay policies and Universal Life policies, especiall y since many
consumers purchase these policies for tax benefits instead of protection. Therefore,
insurance companies and their producers must be aware of this law and its implications.
Using a MEC
Even though the modified endowment contract loses some of the tax advantages of a
life insurance policy, it still retains the death benefit and in certain situations, this can
be worked to the policyowners advantage.
If the problem for the policyowner is Estate planning, a VUL MEC can be used to an
advantage as the policyowner can pay one (or several) large (usually very large)
premiums and then later contribute more premiums should the policyowner find it
helpful or if the need should arise. The policy still has the security-based growth, and
when the policyowner dies, the funds go directly to the beneficiaries without going
through probate of the IRS first. The VUL becomes a valuable planning tool!
However, no one should ever recommend such a plan without discussing the tax
consequences to the prospect and if there is the slightest indication that the prospect
does not completely understand the situation, and then it is imperative that they consult
a tax professional.
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TAXATION AND REGULATION
 The separate accounts within a VUL policy builds cash value within a life
insurance policy, therefore a VUL receives the same favorable tax treatment as
other cash value life insurance policies.
Even though it is regulated as a Security, it still retain s its originality as a life insurance
policy for taxation purposes.
Obviously, premiums are not tax deductible. Cash values accumulate free of current
income taxes (but the legal guideline corridor ratio between cash value and death
benefit must be maintained within the policy).
Death benefit proceeds are tax-free, and lump-sum benefits paid to a beneficiary are
excluded from the beneficiary’s gross income for tax purposes.
Policy loans are viewed as a debt of the policyowner, and not as income or a t axable
distribution. Interest paid on a loan (for non-business purposes) is not tax deductible.
Also, if a policy fails the “7-pay test” it then becomes an “MEC” and loans and
withdrawals are then subject to current income taxes plus a 10% penalty if the
policyowner is under age 59 ½. (See discussions of modified endowment contracts,
MECs.)
In some cases, surrenders and withdrawals and the right to change death benefits
options, can have tax consequences. For instance, upon total surrender, any amount
received by the policyowner that is in excess of the total premiums paid into the policy,
is treated as ordinary income and is taxed as such.
In total, taxation of the VUL has created a very appealing product too many persons,
particularly those who are in a higher tax bracket. As an example, individual life
insurance doubled from 1986 to 1996, but over the same period of time, variable life
insurance (including VUL) grew from approximately $65 billion, to $591 billion.
In order for a VUL policy to meet the definition of an insurance contract and obtain the
favorable tax treatment, there are three tests that must be met:
1. Cash Value Accumulation Test
When the cash value of a permanent life insurance policy exceeds the single
premium that would pay for all future benefits, at that point the policy no longer
meets the IRS definition of life insurance. If a policy does not meet this cash value
accumulation test, the policy is “disqualified,” with the disqualification retroactive
to the policy issue date. All income credited to that policy becomes taxable to the
policyowner.
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Since the insured or the insurance company’s producers do not have access to the
mortality tables and the present value tables necessary to make this “test,” the
insurance company’s home office will provide the necessary expertise to make sure
that the policy meets the test and is considered as life insurance.
2. The Corridor Test
All VUL contracts contain a provision that defines the minimum of pure insurance
protection in comparison to the cash value amount. This minimum amount,
technically guideline minimum sum insured, is the amount that is necessary to
prevent the policy from violating the IRS Corridor rules.
To further make this complicated, the IRS considers the minimum sum insured by
using a published ratio between the face amount of the policy and its cash value.
(See table below) For example, for those under age 40, the death benefit must be
250 percent as great as the cash value at that age. The ratio decreases each ye ar,
eventually reaching 100 percent around age 95, at which time it is said to “mature.”
In the previous discussion of Universal Life, the illustrations show how the face
amount increases after the cash value grows to a certain point, and after that point ,
the “amount at risk” continues to grow, with the “corridor” between the cash value
and the death benefit. The reason for the corridor is that if a policy matures before
age 95, under the IRS Code it is no longer considered as life insurance. So, in ord er
to maintain this ratio, insurance companies reserve the right to refuse additional
payments of premium if they would cause the cash value to increase beyond the
upper limits relative to the death benefit. If the policy fails to meet the corridor test
in any year, the policy is disqualified from inception and all income credited to that
policy becomes taxable income to the policyowner.
3. The Seven-pay Test
Another test! However, if a policy fails the 7-pay test, it still remains as a life
insurance policy, even though it loses the tax advantages of policy loans and
withdrawals. This has been mentioned previously, during the discussion of MECs.
Basically, the test considers that if the total amount a policyowner pays into a life
insurance policy during its first years, exceeds the sum of the net level premiums
that would have been payable to provide paid-up future benefits in 7 years, then the
policy is a MEC. Once a policy is an MEC, it will always be an MEC. And, to
repeat the earlier discussion of MECs, if the policyowner receives any amount from
a loan or withdrawal, that amount is taxed first as ordinary income, then as return of
premium. Plus the 10% penalty if the policyowner is under age 59 ½
One other point on taxation of VULs, if interest accrues after a date of death because of
a delay in settlement, the interest may be taxable. If the interest -only settlement option
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is chosen, the tax exclusion does not apply, and it does not apply to any option selected
by the beneficiary.
CORRIDOR RATIO
Ratio of Face Amount to Cash Value in order to meet the Corridor Test
Age
Percentage
Age
Percentage
Through 40
250%
60
130%
41
243%
61
128%
42
236%
62
126%
43
229%
63
124%
44
222%
64
122%
45
215%
65
120%
46
209%
66
119%
47
203%
67
118%
48
197%
68
117%
49
191%
69
116%
50
185%
70
115%
51
178%
71
113%
52
171%
72
111%
53
164%
73
109%
54
157%
74
107%
55
150%
75 thru 90
105%
56
146%
91
104%
57
142%
92
103%
58
138%
93
102%
59
134%
94
101%
95
100%
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NASD CONDUCT RULES
An outline of the NASD Conduct Rules was indicated earlier. At this point, it would be
advantageous to discuss some of those rules in a little more detail, as they are very
important to the marketing of Variable Universal Life.
 Advertisements and all sales literature must not attempt to mislead investors, in any
fashion or in any way, and must be filed with the proper department of the NASD.
 Any discussions or communications with customers or potential customers regarding
securities must be done in good faith, which means that there must not be any
misleading information, omission of key information, exaggeration or other such
guarantees, particular when comparing funds or accounts.
 Any recommendation given must be reasonable, and if the representative has an
interest in any security’s or product’s success, this interest mu st be fully disclosed.
 The firm or the individual representative may not advertise in any other identity or
name, or anonymously, and the firm must display their name prominently on all
advertising and sales literature.
 If the product’s name does not adequately identify it as a variable life insurance
product, the representative must fully describe what the product is. Further, an
agent should never suggest that VUL policies or their separate accounts are mutual
funds.
 As explained earlier, every prospect must be furnished a prospectus, either at the
time of the first presentation, or mailed to the prospect in advance.
 Under no circumstances should the agent suggest, or even imply that the any
variable product, including VUL, is a “short-term” or “liquid” investment.
 Obviously, the agent must be extremely careful about representing as to what is
“guaranteed” and as to what is not, under a VUL or other variable product.
 Even though separate accounts are, for the most part, patterned after mutual funds –
an agent must not represent or indicate that the separate accounts are mutual funds.
However, it is deemed proper to use the experience of a mutual fund invested in the
same products as the separate account, so as to be shown what did occur with the
mutual fund.
ILLUSTRATIONS
Because the variable products are rather complex and the outcomes are not readily and
accurately forecast without considerable explanation and assumptions, it is extremely
difficult to describe to the average consumer exactly how a VUL fu nctions. However,
the life insurance industry has a checkered past in using illustrations as a sales tool, so
the insurer’s representative or agent must be extremely careful and must always tell the
prospect that all illustrations are hypothetical and bas ed on assumptions, and are
certainly not a guarantee of cash value accumulations. A statement to the effect that the
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prospect understands that the illustrations are not guarantees, etc., are required to be
signed by the prospect by some insurers as a precaution.
Illustrations may use any combination of returns up to a maximum gross rate of 12
percent, but only if the present market conditions warrant such expectations and an
illustration with a “0” return is also provided. The major difficulty suffered by insurers
today with existing blocks of Universal and other interest -sensitive life products is that
the interest rates have declined recently, to levels beyond the comprehension of most
people just a few years ago. Many illustrations were shown with a return of a level
10% interest rate.
All illustrations must show that separate account returns are what determines the cash
values as well as the death benefits, and they must show maximum mortality and
expense charges.
It is NOT appropriate to compare one policy to another based on hypothetical
performances. Further, a hypothetical illustration can only show the relationship
between the cash value and the death benefit value, not whether it is “better” than
another policy. Illustrations comparing VUL to the “buy term and invest the
difference” strategy is considered as appropriate, provided that the hypothetical returns
are identical and other such stipulations are met.
SPECIAL NASD CONDUCT RULES REGARDING VARIABLE CONTRACTS
Variable contracts have special rules as part of the NASD rules and they apply mostly
to the construction of the policy and not specifically to agent’s conduct.
Obviously, when the values of a contract can change daily, it is necessary that the value
must be determined at a specific time, in this case when the payments have been
received - they are considered to have been received when the application has been
received. This further emphasizes that all applications and premiums must be submitted
to the insurance company’s home office promptly.
A representative may not sell contracts through another broker -dealer unless the other
broker-dealer is also a member of the NASD. This also means that an agent cannot sell
a product that his broker-dealer is not licensed to sell or does not have a valid sales
agreement.
Sales charges may not be excessive and the NASD Rules set forth what is considered as
“excessive.”
When a sales charge has multiple payments, they cannot exceed 8.5% of the total
payments due in the first 12 years of the contract or for total length if the contract
length is less than 12 years.
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If the contract has a single payment of the sales charge, the maximums are 8.5% of
the first $25,000 (of the purchase payment); 7.5% of the next $25,000; and 6.5% for
any amount over $50,000.
Section 2300 of the Conduct Rules addresses “suitability” which is the recommending
of products for customers only when the product suits the customer’s needs. This is
addressed to some degree in the following section discussing the us es of VUL.
USES FOR VARIABLE UNIVERSAL LIFE INSURANCE
“Suitability” under the NASD Rules is a difficult prerequisite because of the changing
economic climate in the U.S. VUL can be “used” in many different ways and all the
ways that it can be used, whether “suitable” or not for a particular situation, is beyond
the scope of this text. A few of the uses for VUL are addressed below.

A person does not need a variable insurance policy unless they need life insurance
– obviously. Therefore, those who have legitimate life insurance needs can usually
benefit from VUL. Those that choose VUL are generally those with above -average
incomes.

VUL is an important vehicle for those who use insurance to build or transfer their
estates. Life insurance is the best vehicle for transferring wealth with fewer
hurdles, and the VUL product allows them to transfer their business interests to
family members or to business partners.

The VUL allows an insured to reduce (or skip) premiums when cash flow of the
insured is reduced, and to channel excess dollars into the plan where earnings will
be tax deferred.

For an executive bonus plans, the VUL allows more flexibility so that a bonus does
not need to coincide with a fixed-premium schedule, and the employee can
determine how much coverage they wish and how the cash value is to be invested.

For buy-sell agreements, the potential of growing cash values and death benefits
makes the VUL an attractive funding mechanism. As the business value changes,
so can the coverage without having to lapse or create a new policy. Additional
premium dollars can be put into the plan to help fund lifetime buyouts if desired.

For split-dollar plans, by using VUL, the premium can be reduced in the early
years because of the creation of an immediate cash value. And, when the employer
receives values as repayment of cash-value matching-funds, these values can grow
through investments that the employer selects.
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
VUL can also be used for deferred compensation. It has the advantage of an
above-average accumulation of funds which helps the employer to meet the
promise to pay future benefits. Since these agreements are generally renegotiated
periodically, the coverage can be updated easily.

If a person has securities or securities-based accounts, the VUL offers stability,
and if a person already has life insurance, it would probably be better for them to
add a VUL policy to their insurance portfolio, instead of surrendering old policies.
THE ATTRACTIVENESS OF VUL
Variable Universal Life has a variety of attractive features to consumers, but probably
the most attractive feature is that of flexibility. As any good financial planner can
attest, few financial plans continue in a “straight line,” but fluctuate as circumstances
change as they always do. VUL gives the policyowner the ability to fluctuate or remain
static, depending upon the situation.

VUL is also noteworthy because of its ability to compensate for financial
difficulties, as the policyowner can skip or reduce premiums if things get “t ight”
financially, and there would be (usually) funds that would be available in case of
an emergency.

Policyowners not only control the amount and frequency of premium payments, but
they also determine how the net premiums and cash values will be investe d

Americans are becoming more and more sophisticated investors and appreciate the
value of professional fund management. This professional fund management of the
separate accounts is a very attractive feature, particularly if the individual has
suffered through a period of making wrong choices in investments without
professional guidance.

When the overall financial and economic conditions change – as they have in early
2001 – the separate accounts can change to meet these changes as the policyowners
will make their investment choices based upon their personal and present
objectives and the current performance of the fund(s) that they choose, with the
knowledge that they can change funds as the situation changes and can adjust to
economic swings.
CONSUMER APPLICATION
Bill and Tracy are in their 20’s, with 2 young children and Tracy is staying home until
the children are older, and then will return to her old job. At this time, finances are
“tight” with Bill working as much overtime as possible. During this period of time, the
need for life insurance is because if something should happen to Bill, Tracy would be
left with the 2 children to raise. The VUL policy can meet that objective.
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When Bill and Tracy enter their 30’s, Tracy returns to work, however they have since
purchased a home so their financial needs are greater, and in addition, the costs of a
college education continues to rise so they must start preparing for those expenses. The
VUL policy will allow them to do both – increase the death benefit and at the same
time, increase the cash value of the policy in anticipation of future expenses.
While the increase in cash value helped the children get into college by paying initial
tuition, etc., since both children will be in college at the same ti me, they will need
funds and the discretionary income of Bill and Tracy is reduced drastically. Therefore,
they reduce their premium payments during the college period.
(Continued on next page)
Now that they are both in there 40’s, the children have graduated and are on their own.
They are both doing well in their jobs; they start thinking seriously about retirement.
Their financial goals are changing so the death benefit of the VUL is not as important.
Assuming their incomes rise and there are no layoffs or other financial setbacks, they
will be able to pay higher premiums to generate higher cash values in anticipation of
retirement.
However, if during this period of time, there should be a financial setback, such as a job
layoff because of a terrorist attach on the World Trade Center which created temporary
economic problems (Bill works for an airlines), the VUL policy can be kept active and
the premiums can be reduced as long as is financially needed.
STUDY QUESTIONS
Chapter 5
1.
2.
An insurance policy that is actually a whole life policy that provides a return that is
limited to a portfolio of securities, is
A.
Universal life insurance.
B.
Equity Indexed Annuity.
C.
Variable life insurance.
A Variable life insurance policy
A.
has fixed premiums and a minimum death benefit.
B.
is a risk free investment.
C.
is a combination of term insurance and a securities account.
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3.
4.
5.
6.
7.
8.
9.
The sale of one fund and purchase of another within a Variable life insurance policy is
A.
a taxable event.
B.
not a taxable event.
C.
not permitted.
With a Universal life insurance policy
A.
there are flexible premium payments.
B.
has no guaranteed death benefit.
C.
with adjustable death benefits, a new policy is needed to reflect the different
amount of insurance.
Universal life insurance policies
A.
usually are purchased with a single premium.
B.
like traditional life insurance policies require a fixed level premium payment.
C.
allows the policyowner to skip some premium payments.
Withdrawals from a Universal life insurance policy are
A.
not permitted.
B.
called partial surrenders.
C.
do not effect the death benefit.
A withdrawal from a Universal life insurance policy
A.
is treated the same or a loan from a traditional life policy.
B.
does not have to be repaid.
C.
can be repaid and the death benefit restored to it’s original level..
A total withdrawal of the cash value in a Universal life policy
A.
may cause the policy to lapse.
B.
cancels the death benefit of the policy.
C.
can be accomplished without costs to the policyowner.
Variable Universal Life insurance policies
A.
can be sold by any life insurance agent.
B.
are flexible.
C.
do not require a prospectus.
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10.
11.
12.
13.
14.
15.
A Variable Universal life policy
A.
can be exchanged for a comparable non-variable plan.
B.
does not have “riders” available.
C.
does not have a grace period because there is no connection between the payment
of premium and the continuation of coverage.
The Variable life insurance policy primarily is used to
A.
offset the effects of inflation.
B.
give stability to the interest earned in the life insurance policy.
C.
allow the policy owner the flexibility to vary the premium payments.
The Variable Life insurance policy
A.
leaves the risk of investments to the insurance company.
B.
must be sold with a prospectus.
C.
allows the policyowner an opportunity to increase or decrease the premium.
Will a Universal Life insurance policy
A.
the death benefit can change.
B.
the death benefit is fixed at a stated age, and a level premium is required.
C.
the insurance company can charge the death benefits.
Most Universal Life insurance policies
A.
are purchased with a single premium.
B.
do not allow the policyowner to skip a premium payment.
C.
provide that of each premium paid, a portion pays for the life insurance
protection.
With a Variable Universal Life insurance policy
A.
the premiums are tax deductible.
B.
withdrawals are taxed as ordinary income.
C.
the policyowner controls the amount and frequency of premiums payments.
Answers to Chapter Five Study Questions
1C 2A 3B 4A 5C 6B 7B 8A 9B
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10A
11A
12B
13A
14C
15C
CHAPTER SIX - TAXATION OF LIFE INSURANC E
Life insurance receives favorable tax treatment in the United States and in most other
countries. This section will discuss some of the federal income, estate and gift tax
treatments of life insurance. This is an ever-changing field, as evidenced by the
enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001. This
tax act impacts the estate tax laws in particular, and also income taxation of gift and
generation skipping (GST) taxes. These laws have been published as this text is being
completed, so while every attempt has been made to take these laws into consideration
in this text, there can (and probably will be) changes or clarifications to these laws in
the near future. This act is over 175 pages and being written in IRS format, it is
expected that it will take some time before everyone concerned can feel competent and
confident in the application of these tax changes.
For those interested, the entire tax legislation can be obtained at
http://www.house.gov/rules/1836cr.pdf .
An excellent summary of pension provisions can be found at
http://www.cigna.com/professional/pdf/CPA_0601.pdf
Another excellent summary is presented by the Employee Benefits Ins. Assoc. (EBIA)
at
http://www.ebia.com.weekly/articles/401k010531TaxAct.html
INCOME T AX
PREMIUMS
Premiums paid for life insurance policies and individually issued annuities are
considered as a personal expense and are not income-tax deductible. With some
limitations, contributions to a tax-qualified retirement program funded by annuities
may be tax deductible, and premiums paid for medical expense and long -term-care
insurance premiums are deductible to some degree.
Premiums paid to fund life insurance policies which are payable to a charity may be
deductible as charitable donations, and premiums paid for life insurance, annuities and
health insurance under an alimony agreement, may be deductible.
Premiums that are paid by employers for life insurance, health insurance and annuities
for the benefit of their employees are usually deductible as a business expense.
DEATH BENEFITS
The Internal Revenue Code Section 101(a)(1) is the tax code that states that death
benefits from life insurance policies are exempt from federal taxation, provided that the
death of the insured caused the contract to mature. For instance, proceeds from an
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annuity cash value or any other proceeds that are payable during the insured’s lifetime,
do not qualify for this tax exemption. Death proceeds for the purpose of this code,
includes the face amount of the policy, and any other insurance amounts, such as for
accidental death, face amount of paid-up insurance or additional benefits because of a
term rider.
While this law seems straight-forward, there are exceptions.
TRANSFER FOR VALUE RULE
If a life insurance policy or any portion of a policy, is sold to another person, or
transferred for consideration, the death benefits can lose the tax exemption. The
amount that is taxed is derived by the formula: the excess of the gross death
proceeds, over the consideration paid plus net premiums paid - would be taxable to
the individual as ordinary income.
CONSUMER APPLICATION
Benny had a life insurance policy on his life for $100,000. He needed some cash for a
down payment on a new SUV, so he sold the policy to his brother -in-law Sam, for
$3,000. Nearly 10 years later, Benny passes on. By that time Sam had paid premiums
of $12,000 (net of dividends).
Sam would receive the death benefit of $100,000. Since the total amount Sam paid for
the policy (initial investment of $3,000 plus $12,000 premiums) was $15,000, Sam
would receive $15,000 tax free, but would have to pay taxes on $85,000.
The death benefits collected because of a viatical settlement by a viatical firm, are
subject to this rule.
Note that this rule does not apply in certain situations, such as when the transfer is to a
partner of the insured, a corporation of which the insured is an officer or stock holder,
transfer of a policy to the insured (corporation purchased plan transferred to insured
employee) or a gift or transfer to a tax-free corporate organization.
IRC SECTION 7702 DEFINITION OF LIFE INSURANCE
The IRC Code Section 7702 defines life insurance for the purpose of deciding if a
policy qualifies for favorable tax treatment.
In the 1970’s and 80’s, the tax-deferred savings that individuals could receive through
life insurance, were accumulating at very high (at that time) interest rates. T he tax
savings under these projections were substantial, so the Tax Equity and Responsibility
Act of 1982 (TEFRA) produced a definition of insurance for flexible -premium products,
and the taxation of annuities was changed to reduce the incentives for using annuities
for short-term investment vehicles.
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The Deficit Reduction Act of 1984 expanded the TEFRA act, adding Section 7702,
which provided a detailed definition of life insurance. (It also strengthened TEFRA
rules on annuities used for a short-term investment).
 Failure of a life insurance policy to meet the definition of an insurance policy under
Section 7702, results in the treatment of a life insurance policy as a combination of
term insurance and a side fund (which is taxable).
Universal life policies had their own problems. Traditional insurance policies had an
actuarial relationship between the death benefits, the cash value and the premiums.
However, some UL policies had cash values that were substantially more than the
amount that would be actuarially required to fund future policy charges. Therefore, it
was much more like an investment than life insurance (if it walks like a duck and
quacks like a duck…).
Congress rose to the task again, and mandated that for life insurance policies to b e
considered as life insurance for tax reasons, they must be considered life insurance
under the applicable state law. In addition, it must meet one of two tests:
The cash-value accumulation test was applied mostly to traditional cash-value
policies, and it required that the cash surrender value cannot at any time exceed the
net single premium that would be required to fund future contract benefits. There
were stipulations as to mortality tables and interest rate in the calculations.
For universal life and other interest-sensitive policies, the policy must meet a
guideline premium requirement and a cash value corridor requirement . (This is
also discussed under the Interest Sensitive Life Insurance section.) There were
stipulations as to mortality tables and interest rates in the calculations of the
guideline premium (either guideline single premium or guideline level premium).
The cash value requirement is met if the death benefit of the policy is at least equal
to a stipulated percentage multiple of the cash value.
Failure to meet these requirements means that the cash value will not be treated as a
death proceed but the net amount at risk will meet the qualifications under Section
101(a)(1).
OTHER CAUSES FOR PROCEEDS TO BE TAXED
If there is no insurable interest at the time of policy issue, that makes the policy a
“wager” and policy proceeds would be taxed as ordinary income.
Life insurance death benefits received under a qualified pension or profit -sharing plan
can create a taxable situation, as can policy proceeds received by a creditor on the
insured/debtor’s life. Policy proceeds that are received as compensation (discussed
under Business Uses of Life Insurance) or dividends from a corporation; received as
alimony; or received as restitution for embezzled funds can be taxed.
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Alternative Minimum Tax
The Alternative Minimum Tax is discussed in the Business Uses of Life Insurance
section as it affected death proceeds that are payable to a corporation. This tax was
devised as a “catch-all” as it makes sure that no taxpayer with substantial income is
able to avoid tax liability.
Life insurance benefits that are received by a corporation, and any increase in the policy
cash value, are items that can create an alternative minimum tax situation.
NOTE: At the time this text was being prepared, Congress was seriously debating the
repeal of the alternative minimum tax and while it will probably be passed in the House,
the Senate may or may not pass it at this time. If this tax is repealed, references to this
tax should just be ignored as a factor in this discussion.
TAXES ON SETTLEMENT OPTIONS
The favorable tax treatment of life insurance proceeds is not affected when settlement
options are elected, with the exception that income taxes may be due on any interest
paid on the proceeds. Therefore, under the interest option, interest received by the
beneficiary is taxable as ordinary income.
Under life income settlement options and installment options, every payment is
considered to be comprised of principal and interest. The part that is considered return
of principle is not taxed. Amounts that are more than the annual prorated principal are
considered as interest and taxable interest.
Under the fixed-period option, the amount held by the insurer is divided by the number
of the installments within that fixed period, and the excess of each payment over this
amount is considered as taxable interest. Under the life income settlement option, the
amount held by the insurer is divided by the recipient’s li fe expectancy. The methods
used to determine the “amount held by the insurer” is detailed and beyond the scope of
this discussion. It is furnished to the policyowner or beneficiary by the insurer.
TAXATION OF LIVING PROCEEDS
“Living proceeds” include dividends, cash values, matured endowments, policy loans
and accelerated death benefits.
MODIFIED ENDOWMENT CONTRACT (MEC)
The Modified Endowment Contract (MEC) has been discussed earlier in the Chapter on
Interest Sensitive Life Insurance. To reiterate, a MEC is a life insurance policy that
was issued after June 20, 1988, and meets the IRC Section 7702 definition of life
insurance, but fails to meet the seven-pay test, or other test, as described earlier. The
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IRC Code was amended because of the practice of many insurers to sell single-premium
life insurance policies as a tax-deferred instrument, instead of providing protection
against premature death.
DIVIDENDS
Dividends are usually considered a nontaxable return of excess premium. Exceptions
are if the policy is an MEC (or fails to meet the IRS definition of life insurance), or if
the dividends received (under a policy other than MEC) exceeds the total of the
premiums paid, then this excess will constitute ordinary income.
CASH VALUE
The interest credited to a life insurance policy’s cash value is not taxable if the policy
meets the IRS definition of a life insurance policy (which also applies to MECs)
For a lump-sum cash value surrender payment on life policies, the cost recovery rule is
invoked, whereby the amount to be included in the policyowners gross income after
surrender is the excess of the gross proceeds received over the cost basis. The cost
basis usually is the sum of paid premiums less the sum of any dividends received in
cash (or credited against the premium). Gross proceeds are the amounts paid on
surrender, including the cash value of paid-up additions and dividends accumulated at
interest.
Losses that may arise upon the surrender of a life insurance policy, usually cannot be
deducted as a loss for tax purposes.
SECTION 1035 POLICY EXCHANGES
It is important to be familiar with Section 1035 (IRC Section 1035) exchanges as with
fluctuations in interest rate and the development of new policies, policies are frequently
being exchanged for other life insurance policies. If Section 1035 is not strictly
applied, there can be important tax consequences.
As important as this tax code is, it is relatively simple. To qualify for the Section 1035
policy exchange, there are three criteria:
The exchange must be of
 A life insurance policy for another life insurance policy, endowment or annuity
contract;
 An endowment for an annuity contract or another endowment of no greater maturity
date that the replaced endowment; or
 An annuity for another annuity.
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When a Section 1035 exchange occurs, any gain on the old policy is “rolled into” the
new policy and there is no gain for tax purposes. The new policy’s cost basis is
adjusted to include the basis of the old policy.
As simplistic (comparatively speaking, considering other tax legislation) as this tax
code is, there is not always a clear distinction between an exchange – and a surrender
and purchase. However, as a result of several IRS “private letter rulings” it is accepted
that the contract that will be replaced should be assigned to the replacing insurance
company, without the policyowner actually receiving any surrender values.
CONSUMER APPLICATION
Bob has a life insurance policy that was issued in 1968, and the cash value grows at an
astounding 3.5% and he has no flexibility. Therefore, his brother -in-law convinces him
that he should replace his old policy with a new Variable Universal Life policy. Bob
agrees, but notes that he has cash values of $23,000 in his old policy. Therefore he
requests that the surrender values of $23,000 be sent directly to him and then he will
determine how much he wants to pay for the new policy – after all, he needs a down
payment for a new SUV.
However, his brother-in-law points out that if he does that, the transfer will no longer
be tax-protected under Section 1035, and he could have a sizeable taxable gain.
MATURED ENDOWMENTS
At one time, Endowment contracts were popular as a retirement -income vehicle. They
are no longer popular, however there are many endo wments that are maturing. The
proceeds are taxed the same as if the policy were surrendered, if the policy meets the
IRC definition of a life insurance policy. (Note that some older policies have been
“grandfathered” and while not meeting the definition, the cost recovery rule will apply).
The cost basis is subtracted from the gross proceeds to arrive at the taxable income.
POLICY LOANS
Policyowners can obtain policy loans from a life insurance policy using the cash value
as security. The interest rate that is charged is stated in the contract.
Policy loans interest paid by individuals is not tax deductible, but interest paid on a
policy that is owned by a business and covering the lives of key persons (officers and
20% owners) may be deductible, subject to certain conditions. Deductions must be only
on loans on policies that cover key persons and the loan amount cannot be for more
than $50,000 per insured individual. The key persons may not be less than 5, or the
lesser of 5 percent of the total officers, or 20 individuals.
This deduction does not work under the 4-in-7 exception wherein a deduction is
allowed if no part of at least 4 of the first 7 annual premiums due on the policy is paid
through borrowing either from the policy or from other sources. If, during the first
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seven years, the borrowed amount exceeds more than 3 years premiums regardless of
when the borrowing takes place, this test is “violated”
Generally, taking a loan from an insurance policy does not create a taxable action. Of
course if the contract is a MEC or an annuity, loans are taxable as income in proportion
to the excess of the cash value exceeds the cost basis. There is a 10 percent penalty tax
if the loan is taken out before the insured reached age 59 ½.
Since policy loans reduce a policy’s cost basis, a policy with a large outstanding loan,
the net cash surrender value, which is the cash surrender value less the loan, can be
quite small. Therefore, if the policyowner surrendered the policy, the check could be for
a smaller amount than expected. However, the owner could face an extremely large tax
bill because of the negative cost basis. Unfortunately, many surrenders occur because
the policyowner faces financial difficulties, and the addition of a large tax bill could be
disastrous.
ACCELERATED DEATH BENEFIT TAXATION
The Accelerated Death Benefit, as discussed earlier, allows an insured to collect part or
all of the death benefits if the insured is terminally ill (or chronically ill). There is a
difference, as the accelerated death benefits paid in connection with a terminally ill
insured will be treated as if the insured had died, so there is no taxation. Similar to a
viatical settlement, a physician has to attest that the insured is expected to die within 24
months.
ANNUITIES
Annuities are not discussed in detail in this text, however it should be noted that for
taxation purposes, generally speaking, interest credited to the cash values of
individually owned annuities accumulate on a tax deferred basis. For taxat ion of
annuity payments, the rules are the same as stated for settlement options.
FE D E R A L E S T A T E T A X
Life insurance proceeds can be subject to estate taxation. In addition, using life
insurance for estate planning requires a knowledge of federal estate tax laws. The new
2001 tax act affects the estate taxation substantially, at least for the next 10 years
(unless changed again). A later Chapter on Life Insurance in Financial and Estate
Planning will detail the uses of insurance for planning purposes.
The federal estate tax is the tax on a person’s right to transfer property on his/her death.
It is calculated on the value of the property, and must be filed and estate taxes paid
within nine months of the death of any US citizen or resident who leaves a gross estate
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above a specified amount. This amount was $600,000 for many years, prior to the
Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). (For details
on EGTRRA 2001 go to page 113)
In order to calculate the estate tax due, the first step is to measure the value of the gross
estate, which is the value of all property or interests in property owned and/or
controlled by the decedent.
Next, allowable deductions such as funeral and administration expenses, debts of the
decedent, bequests to charities and the surviving spouse, are determined, and subtracted
from the gross estate to form the adjusted gross estate.
To the taxable estate is added adjusted taxable gifts which then determines the tentative
tax base. Then the appropriate tax rate is applied to the tentative tax base to form the
tentative federal estate tax.
From this tentative federal estate tax is subtracted certain gifts and other taxes paid,
including the unified credit which is a tax credit that can be applied to offset estate and
gift taxes.
NOTE: Gift Tax Exemptions and Rates are identical to Estate Tax Exemptions and
Rates, except in the exempt amount remains at $1,000,000 from 2002 to perpetuity(?),
and the Rate in 2010 and thereafter is 35%. This is expl ained further later in the text.
The IRC provides that the values of 4 classes of gifts must be included in the gross
estate.
1. The value of certain gifts made by the decedent within 3 years of his or her death, is
added back to the gross estate (Anticipation of death provision).
2. The value of gifts where there is a life interest retained, is added back to the gross
estate. These are the type of gifts where the decedent gifted property to someone
else, but retained (for life) the right to receive income fro m the property, to use the
property or designate as to who will eventually receive the property or income from
the property.
3. The value of gifts that take effect at death may be included in the gross estate. This
is when property is given to someone, but they cannot take possession only when the
donor dies.
4. Revocable gifts, wherein the decedent retained the power to alter, amend, revoke or
terminate a gift, are included in the gross estate.
Annuities
If annuity benefits continue after death of the annuitant, the present value of the
survivor benefits might be included in the gross estate. If the decedent paid NO part of
the premium of the annuity, then the entire value of the survivor benefits are excluded
from the gross estate. The cash value of an annuity during the accumulation period is
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included in the decedent’s estate to the extent that the decedent made contribution to its
purchase.
Joint Owned Property
For property held by 2 or more persons during the lifetime of the decedent, the
decedent’s interest is included in the decedent’s gross estate. If the property is held in
joint tenancy with right of survivorship and the ownership interest passes automatically
to the survivors in the case of the death of one of the owners, then 100% of the value of
the property is included in the decedent’s estate, less the amount that the survivors
contributed to the purchase of the property.
CONSUMER APPLICATION
Four golfing buddies decided to each invest in a small golf club repair and
manufacturing business, and each person put in $100,000. Abe, the older of the golfers,
made a hole-in-one and became so excited, he had a heart attack.
In determining the value of Abe’s interest in the business, it was proven by the
partnership papers that each person owned 25% of the business. The business had done
much better than expected, and from the original $400,000 investment, the value was
now $1 million.
25%, Abe’s percentage of the business, or $250,000, was included in his estate.
Tenancy by the Entirety
Property owned by spouses is a joint ownership that provides a right of survivorship.
However, the property is considered to be owned 50% by each spouse, thus 50% of the
property is included in the estate of the first spouse to die.
Tenancy in Common
This is a joint ownership where each member owns his/her share outright, therefore the
decedent’s estate would include his/her proportionate share.
Community Property
In community property states, property acquired during marriage is the property of each
marriage “community.” Upon the death of the first spouse to die, 50% of the property
value is included automatically in the decedent’s estate, regardless of how much of the
property was paid for by the decedent.
Power of Appointment
If an individual has the right to dispose of property that it not owned by the individual,
this is called a general power of appointment and the value of that property is included
in the gross estate
If the individual has a general power of appointment and if the individual’s right to any
of the property is limited by requiring the individual to meet certain standards, the
property will not be included in the gross estate.
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A special power of appointment is where the individual has the power to appoint
another person other than the decedent, his estate or creditors to receive the property. In
this situation, the property would not be included in the gross estate.
CONSUMER APPLICATION
Cecil Worth III is the recipient of a large trust established by his grandfather, under
which he receives a lifetime income of $100,000 per year. Cecil has the power to
withdraw all of part of the trust fund (trust corpus) during his lifetime. Cecil elects to
receive only the income from the trust and he does not withdraw any of the trust fund.
At Cecil’s demise, he would be considered to have a general power of appointment, and
the entire value of the trust would be included in his estate.
Had his grandfather set up the trust to pay Cecil $100,000 a year if he becomes an
attorney and remains a member of the bar in good standing, then the value of the trust
would NOT be included in his gross estate.
If the grandfather had stipulated that Cecil could appoint others to receive property
from the trust, for instance, Cecil appointed his son as beneficiary of the trus t if Cecil
should precede his son in death, then the value of the trust would NOT be included in
his gross estate.
Life Insurance in the Gross Estate
Life insurance is not included in the gross estate, unless
 the life insurance proceeds are payable to or for the benefit of the insured’s estate,
or
 the insured possessed any incidents of ownership in the policy at the time of death.
If the estate is the beneficiary, death proceeds are included in the gross estate even if
the insured was not, in fact, the policyowner. An excellent reason why the
beneficiary should never be the insured’s estate. It also points out why there should
be sufficient contingent beneficiaries.
The second part, incidents of ownership, is a little more difficult as the insured must n ot
own ANY incidents of ownership – such as right to change beneficiary, surrender the
policy, assign the policy, obtain policy loan, or any other policy right. Just the
ownership of one of these policy rights makes the proceeds includible in the gross
estate.
If a policy is sold or transferred or given to another person by means of absolute
assignment, then the proceeds would not be included in the gross estate. However, if
the policy is a gift, and the gift is given within 3 years of death, it would be considered
as a gift “in anticipation of death” and would not still be included in the gross estate.
Taxable Estate
From the gross estate, deductions as discussed earlier, plus unreimbursed losses,
charitable transfers, and a special deduction for family-owned business are subtracted.
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The marital deduction is perhaps the most important deduction. The value of property
left to a surviving spouse may be deducted, and if all property is left to the spouse, the
value of the estate is zero. However, only the property that would be included in the
surviving spouse’s estate qualifies for the marital deduction, an interest in property only
during the lifetime of the spouse would not qualify for the deduction. There are
exceptions to this rule, provided the surviving spouse is entitled to a lifetime income
payable from the property (must be paid at least annually): no one can give, or in any
way divert, any part of the property to anyone except the spouse during the lifetime of
the spouse; and the executor makes an irrevocable election to have the marital
deduction apply.
After certain adjustments, the Federal Estate Tax is determined by certain credits:
1. The tax laws permit a unified tax credit which is applied against estate and gift taxes
on a dollar-to-dollar basis.
2. States levy their own forms of estate taxes and federal laws allow a credit for state
taxes paid, subject to a maximum. This deduction will be phased out by 2005. (See
later discussion)
3. Taxes paid on previous gifts can be taken as a credit against the estate tax.
4. If the decedent paid estate taxes and the heir dies shortly thereafter, part or all of the
estate tax may be taken as a credit against the estate tax.
GIFT TAX
The gift tax is another “transfer tax” levied against a party that transfers property to
another person. Where the estate tax comes into play after a person dies, the gift tax is
applicable when a person is alive. A lifetime gift to an individual incurs a federal gift
tax basically at the same rate as the estate tax as indicated earlier.
The federal gift tax law is not designed for the usual holiday, birthday and other family
gifts, and therefore there is an exclusion of $10,000 per person per year, by one person.
For instance, a married couple could give $10,000 each to thei r son (total of $20,000)
every year without paying a gift tax. The gift must be of a present interest, i.e. they
must have possession of the property immediately instead of at some time later in the
future. Gift splitting is when one spouse makes a gift to someone other than his spouse,
it is considered as being one-half made by each spouse.
The gift tax marital deduction allows for tax-free exchanges between spouses, and is
allowed with no limit.
Gifts of Insurance
If the insured assigns any of his/her rights under the policy to another person, the
taxability question depends upon whether the rights have been assigned for less than
adequate compensation. The value of the policy for gift tax purposes is its market
value, which is the cost of replacement. This value is determined by a rather technical
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formula which basically is that the value of the gift is composed of the terminal reserve
at the time of the gift plus the unearned premium.
If the policy is a single premium policy or annuity, or a pai d-up policy or annuity, then
the replacement cost is the single premium that an insurance company would charge for
a comparable contract issued at the insured’s (or annuitant’s) attained age.
If a person makes a gift of insurance premiums on a policy that the person does not
own, then that premium is considered as a gift. Premiums paid by a beneficiary on a
policy that he/she owns are not gifts.
Life insurance proceeds are usually not considered as “gifts.” There can be an instance
of the proceeds being a gift when one person owns the policy, another person is the
insured, and yet another person is the beneficiary. In this case, the proceeds would be
considered as a gift from the owner of the policy to the beneficiary. If a spouse owns a
policy on the other spouse, and the children are beneficiaries, even though there is no
intent to have a gift made, in effect there is a gift from the spouse that owns the policy
to the children.
GENERATION-SKIPPING TRANSFER TAX
In order to “plug a hole” in the tax laws, the IRS created the generation-skipping
transfer tax (GST), which is levied when property is transferred to persons who are two
(or more) generations younger than the person transferring the property. The purpose is
to keep very wealthy persons who attempt to avoid a generation of taxes by passing
property to another generation (the “skip” generation). Life insurance death benefits
can be subject to GST taxes if they are paid to one of the “skip” persons. This can be
avoided by not including the death proceeds in the insured’s estate through the
appropriate use of life insurance trusts (discussed in the following chapter).
E CO NO MI C GRO W T H AND T AX RE L I E F RE CO N CIL IAT I O N ACT 2001
The EGTRRA of 2001 has made substantial changes in estate and gift taxat ion, and in
the generation-skipping tax.
P R I N C I PA L FE A T U R E S
This tax act has many features that affect estate planning, however many people have
(wrongly) assumed that since many of estate planning features are gone, they will not
have to worry about trying to avoid probate, transferring their estate after death to the
chosen heirs, protection of assets after death, etc. These can be considered as “non -tax”
issues, and the tax act has no bearing on these factors and there is little change, if any,
in estate planning to alleviate these concerns.
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This act changes Estate and Generation Skipping Tax (GST) and rates, with the exempt
amount presently of $675,000 increasing to $3,500,000 in 2009 and becoming unlimited
in 2010. The tax rates decrease from the present 55% to 0% in 2010. But don’t
applaud yet (the fat lady hasn’t sung) because the act itself expires on Jan. 1, 2010.
There are no guarantees that Congress will renew the bill at that time.
First, Tables showing the changes in Estate and GSP Tax Exemptions and rates.
TABLE ONE
Scheduled Changes in Estate and GST Tax
Exemptions & Rates (Gift Taxes Not Included)
Year
Rate
Exempt Amount
2001
55%
675,000*
2002
50%
1,000,000
2003
49%
1,000,000
2004
48%
1,500,000
2005
47%
1,500,000
2006
46%
2,000,000
2007
45%
2,000,000
2008
45%
2,000,000
2009
45%
3,500,000
2010
0%
Unlimited
'Unchanged from prior law
The top rate for estate and GST taxes decrease in a series of annual steps through 2007.
INCREASE OF EXEMPTIONS
The estate tax united credit exemptions and the generation skipping tax exemptions,
increase to $3.5 million in 2009. The exempt amount is the value of the estate that is
free of any estate taxes for the year that is shown. And, as stated earlier, this tax
disappears totally in 2010.
ESTATE AND GST TAX RATES
The top rate for estate and GST taxes decrease through 2007. The percentage that is
shown in the previous Table, is the maximum tax rate (estate or GST) for the year
shown, and the minimum is still 37%. So, the amounts that hit the exempt amount will
be taxed at 37%, and amounts of estates over that amount will be taxed at the rate
shown.
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REPEAL OF TAXES
As mentioned earlier and often, estate taxes and GST taxes are repealed as of January 1,
2010. As Art Linkletter, well into his 80’s, recently stated, he now has reason to live
for 10 more years, so that he can make sure that the money tha t he has worked so hard
for, for so many years, can now go to the people that he wants it to go to, and not to the
Federal Government. Most people with estates large enough to be concerned with
estate planning, will second that with a resounding “Amen!”
For the estate planner, this is a mixed blessing. There really is more need for an active
estate planner now as thanks to the political and tax ramifications, estate planners
should stay busy by frequent reviewing estate plans.
GIFT TAX EXEMPTION AND RATES
The Gift Tax unified credit exemption amount for lifetime gifts will increase to $1
million in 2002, and then it will stay there until changed by subsequent law. There is
no “sunset” for gift taxes – they do not expire in 2010.
However, as seen in the Table 2, gift tax rates will decrease through 2010 and the rate
changes are the same as the estate and GST rate changes. However, the gift tax is not
repealed in 2010 and a final rate is set at 35% in 2010.
TABLE TWO
Scheduled Changes in Gift Tax
Exemptions and Rates
Year
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010+
Rate
55%
50%
49%
48%
47%
46%
45%
45%
45%
35%
Exempt Amount
$
675,000*
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000**
* Unchanged from prior law
** Permanent – it is hoped.
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STEP-UP BASIS IN ESTATES
Starting in 2010, the step-up in basis in estates will be limited to a maximum of $1.3
million step-up in addition to the estate’s original basis when it is passed to a non spouse and $3 million if it is passed to a surviving spouse. Before 2010, the estate will
have an unlimited step-up in basis. There are several rules and provisions set forth in
this tax act, which are beyond the purview of this discussion.
While the federal estate taxes are being phased out, the step -up in basis will be partially
lost.
CONSUMER APPLICATION
Bertram had spent $500,000 for his property that would be included in his estate when
he died. At his time of death, the estate was valued for fair market value, at $3.5
million, or an appreciation in the estate of $3 million. Since the estate was not left to a
spouse, the additional step-up in basis allowed was only $1.3 million, therefore there
was capital gain taxes due on $1,700,000.
CONSUMER APPLICATION
Franklin left his estate to his wife, his surviving spouse. Franklin had paid $500,000
for the property in the estate, but the estate had a fair market value of $3.5 mil lion when
he died, so the estate had appreciated $3 million. Under the 2001 tax act, since it was
left to the spouse, $3 million additional basis was allowed, therefore there was no
capital gain.
The 2001 tax act limits the step-up in basis by shifting the taxation from estate taxes to
capital gains taxes for the larger and more valuable estates. The result of this is that
this partial loss of step-up basis will create capital gains taxes which will be paid by
many heirs. Remember that capital gains taxes only occur upon sale of property, so if
inherited property is not sold, there are no capital gains taxes (at that time).
The capital gains taxes will be created because heirs will want to sell the decedent’s
real estate, investments and other such taxable assets. The estate will get the decedent’s
basis in these assets, plus up to $1.3 million for non -spouses and $3 million for spouses.
The practical effect is that an estate worth only $1.5 million could very well be subject
to considerable capital gains taxes when the heirs sell the assets.
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CREDIT FOR DEATH TAXES AT THE STATE LEVEL
There are also scheduled changes in the size of the deduction allowed for state death
taxes:
TABLE THREE
EGTRRA Changes in Size of
Deduction Allowed for State
Estate Taxes
Year
2002
2003
2004
2005 & thereafter
Loss of Deduction
25%
50%
75%
100%
The federal credit given to estates for payment of the estate’s death taxes at the state
level will be reduced as shown in the above table. As to how thi s will affect state death
taxes, is anybody’s guess, as it is almost certain that some states will change their death
tax laws soon, either to increase taxation or to better integrate with the new federal law.
In some states, this will not make any difference in the total amount of estate taxes
paid, but in others it will increase the amount of estate taxes paid.
Some experts are predicting that states will find that since taxes are not being paid to
the federal government at the same rate that they hav e been in the past, this will open
the doors for politicians at the state level to see this as an opportunity to increase the
state death taxes. After all, people are used to paying large death taxes, so they should
not scream too loudly if the money goes to the state instead of the federal government.
Anyway, the thinking of many politicians probably is that this would affect only the
wealthiest citizens and there are not too many of them, and besides, they will not really
be aware of it as they will be dead when their estate is plundered (taxed).
DEDUCTION FOR FAMILY OWNED BUSINESS
Presently, an estate where a family-owned business exists, has a total estate tax
deduction of $1.3 million. This will be repealed, but since the total exempt amount is
raised to $1.5 million in 2001, there is little effect, one way or the other.
ANNUAL GIFT TAX EXCLUSION
The present gift tax law remains the same, i.e., one can give a tax -free gift to another
person of $10,000 each year, as can spouses. It is indexed for inflation, so this amount
will increase by $500 increments to compensate for inflation.
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After the year 2009, gift donors will be required to provide information about the gift
property, such as fair market value and the basis of the gift. A donor who does not
make such a report is subject to a penalty.
CAPITAL GAINS EXEMPTION
The $250,000 per spouse capital gains exemption on personal residences will be applied
to the estate for the benefit of the heirs. If an estate, an heir or a qualified trust sells a
decedent’s principal residence within three years of the decedent’s death, the seller will
be able to use the two-out-of-five-year rule for the decedent’s use of the residence
while still alive. Where it is applicable, the seller then can claim a capita l gain
exclusion of $250,000, on top of any step-up in basis under the new tax act that may
have been added to the residence’s original basis.
STUDY QUESTIONS
Chapter 6
1.
2.
3.
Premiums paid
A.
for life insurance are tax deductible.
B.
by an employer for group life insurance are income tax deductible.
C.
for a Variable life insurance policy are deductible except for the money going into
the separate account.
Death benefits
A.
from Term policies are treated differently by the Internal Revenue Code then from
Whole life policies.
B.
collected because of a viatical settlement are tax exempt.
C.
from life insurance policies are usually exempt from federal taxation.
When a beneficiary of a life insurance policy receives the death benefit
A.
as a lump sum the entire benefit is tax exempt.
B.
under an interest only settlement option, the proceeds are tax-free.
C.
under a life income settlement option all proceeds are taxed as ordinary income.
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4.
5.
6.
7.
Individual policyowners
A.
can borrow from their Term life insurance policies.
B.
can borrow from their Whole life insurance policies.
C.
can borrow from their Whole life insurance policies interest free.
If there is an Accelerated Death Benefit provision in the life insurance policy
A.
the insured can collect the death benefit before death.
B.
and the insured collects the death benefit it is taxed as ordinary income.
C.
and the insured becomes disabled the insurance company will make the payments
for him/her.
The federal estate tax
A.
has been eliminated.
B.
must be paid on April 15 following the year of death.
C.
is a tax on a person’s right to transfer property at his/her death.
Life insurance proceeds are
A.
always included in a decedent’s gross estate.
B.
included in the gross estate, if the estate is the beneficiary.
C.
taxable even if the beneficiary is an individual and not the estate.
8. The marital deduction
A.
applies to property left to a surviving spouse.
B.
applies even if the property would not be included in the surviving spouses estate.
C.
would apply to a life insurance policy whereby the spouse is beneficiary.
9. Gifts between spouses are tax free because of
A.
gift splitting.
B.
the gift tax marital deduction.
C.
the annual exclusion.
10. Under the Economic Growth and Tax Relief Reconciliation Act 2001
A.
income taxes are no longer applicable after 2010.
B.
the gift tax in the year 2010 will be zero.
C.
the estate tax decreases to 0% in 2010.
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11.
12.
13.
14.
15.
If a life insurance policy is sold or transferred
A.
the death benefits can loss the tax exemption.
B.
the beneficiary cannot be charged.
C.
the tax exemption, on the death benefit does not change.
If the policyowner had no insurable interest in the insured,
A.
at the time of the insured’s death, the insurance company will not pay the death
benefit.
B.
at the time the policy was issued, the death benefits will be taxed as ordinary
income.
C.
when the insured died, the death benefits are taxable.
If an individual borrows from their life insurance policy
A.
the loan is interest free.
B.
and pays interest on the loan, the interest is tax deductible.
C.
the loan is expected to be repaid.
The Gift Tax
A.
rates are the same as Estate Tax rates.
B.
is imposed on all transfers of property, if there is no consideration paid to the
donor.
C.
is payable by the donee, the one that received the property.
Property owned by spouses jointly, with the right of survivorship is called
A.
tenancy by the Entirety.
B.
tenancy in Common.
C.
joint tenancy with the right of survivorship.
Answers to Chapter Six Study Questions
1B 2C 3A 4B 5A 6C 7B 8A 9B
10C
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11A 12B
13C
14A 15A
CHAPTER SEVEN – LIFE INSURANCE IN FINANCIAL &
ESTATE PLANNING
Financial planning is the acquisition and employment of assets in order to maximize the
return on these assets through (1) establishing financial planning objectives, (2)
development of financial plans by which these objectives can be achieved, (3)
establishing a budget by which funds can be allocated to the purchase of the financial
assets, and (4) review, and if necessary, revise the financial plan to make certain that
progress is being made toward the achievement of the planning objectives.
A complete discussion of financial planning is beyond the scope of this text – it is a
profession and many texts are available on just financial planning. However, life
insurance plays an important role in financial and estate planning and needs to be
discussed in this context.
In fact, life insurance plays the most important part of the establishment of financial
planning objectives. The goals of the financial plan would include the following:
 Maintaining the Standard of Living. Providing for basic needs (food, water,
clothing, shelter) and discretionary items, such as automobiles , entertainment,
vacations, etc.
 Providing funds for emergencies, one of the accomplishments of insurance.
 Protection against uncertainty of a financial loss, particularly premature death.
 Accumulation of wealth through investing, enjoying a reasonable ret urn on assets,
eventually leading to financial independence.
 Estate planning which is the distribution of the invested assets held for the purpose
of the accumulation of wealth in a tax efficient and effective manner. This is treated
as a separate action, but factually, it is all part of financial planning.
In the determination of a financial and/or estate plan, the “risks” involved in attempting
to achieve the objectives must be carefully considered. In this sense, life insurance
becomes a tool for risk management, as does property and casualty insurance for risk
management of property because life insurance guarantees that an individual’s family
and dependents or business, will not have to suffer the risk of financial loss in case of
premature death of the individual.
In accumulating wealth, the savings element of life insurance is an important tool in
risk management. The costs of education continues to climb, and a premature death
without insurance can cause a dependent child to lose the advantage of a college
education, or the privilage of attending the college of their choice.
In order to enjoy retirement, life insurance now offers a wide variety of fixed -value and
variable investments which can assist in building up the retirement fund. After
retirement, fixed or variable policies can provide tax -deferred investments not available
in other investments.
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Because of the tax deferral privileges of life insurance, taxes are minimized. More than
just being a vehicle that pays a sum in case of premature death, life insurance is
purchased usually for one (or more) of the following reasons:
 Replacing income lost by death of the wage-earner.
 Paying off an outstanding debt, such as home mortgage or auto payment, in case of
the death of the person responsible for the debt.
 Creating savings that can be used for educational purposes or emergency fund, upon
the death of the person who had been providing these funds.
 To replace the value of wealth that is given away or consumed during life and has
not been replaced for the heirs.
 To pay death taxes, as discussed earlier in detail.
 Business purposes, for business continuation plans, key employee benefits and
compensation packages for employees and officers.
DETERMINING FINANCIAL OBJECTIVES
Basically, financial objectives are either cash objectives, or income objectives.
Cash Objectives
It is relatively easy to determine cash objectives. Basically, they are the need to pay for
outstanding obligations, such as mortgage, auto payment, credit card debts, etc., a nd the
information on these amounts are readily available. Educational funds are a little more
difficult, but assuming a rate of growth of tuition and other college costs, an
approximation can be reached. Final expenses can be more easily estimated.
Income Objectives
This can be very technical and difficult, even though the best that can be expected is an
approximation. First it must be determined how much money will be needed for the
survivors, taking into consideration all sources of income, such as government or
employee benefits. The changing of family responsibilities that naturally occur as the
family ages, must be considered. Inflation, while quite low at this particular time, can
create havoc with a financial plan that does not take it into c onsideration.
The methodology used for life insurance planning is quite technical, although the
purposes are straight-forward. The net income amounts are usually converted to a
single-sum present value equivalent, taking into consideration the future i nterest
growth. While the planning process is simple in concept, the assumptions that must be
used to calculate future inflation and interest rates make the analysis quite complex and
the technique is (way) beyond the scope of this text.
The complexity of these determinations has created a market for computer programs
and because there are so many assumptions that must be made, the computer programs
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help with the “number-crunching”, and also it is a valuable tool for analyzing different
scenarios. With the need to revise plans (particularly because of the new tax laws)
periodic revisions can be more easily accomplished.
ESTATE PLANNING
Estate planning is concerned with the distribution of property at death, but it must be
considered as an important part of the overall financial planning procedure. Life
insurance plays an important part of estate planning as it can provide the necessary cash
to pay estate tax and any other liabilities, and also fund the income needs of surviving
family members. Life insurance is the primary asset of many estates, and consequently
is a major source of family income after an estate owner dies.
DISPOSITION OF PROPERTY AT DEATH
Simply put, all property owned by an individual will pass to another at death - the
method as to how it will pass is what makes the difference.
Probate
Probate is the most important method of passing property for individuals. Probate is
the process of a court by which the Will of an individual is presented to the court, who
then appoints someone to administer the affairs of the estate in accordance with a Will.
If there is no Will, the property will pass to court or state law -stipulated persons.
Nature of property ownership
Property can pass because of the nature of the ownership, such as “joint tenancy with
right of survivorship” would dictate that upon the death of one of the owners, the
property would transfer to the other owner.
Contract
Property can pass by contract, and if contracts are established prior to death that call for
payments at or after death, the property will pass outside the probate estate. Certain
Trusts and life insurance contracts are the best known of these contracts.
By Law
By law, certain property can pass outside of probate, such as Social Security survivor
benefits.
WILLS
Wills are extremely important for estate and financial planning. A Will is a legal
declaration of an individual’s desires as to the disposition of their property on their
death. Certain salient points should be considered in any discussion of Will s.
 A person who dies without a Will dies intestate. In that situation, the court decides
how the property is to be distributed, and is based primarily on consanguinity (blood
relationship) instead of the decedent’s desires. If there are no relatives, the n the
property reverts to the state (escheats).
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 A Will gives the maker an opportunity to name the beneficiary and to name an
executor.
 A Will permits implementing plans to save income, estate and gift taxes.
 Wills can authorize an executor to continue a business, or it can direct a sale.
 A Will is ambulatory, which means it does not take effect until the death of the
testator (the person making the Will) but can be changed or revoked at any time. A
change to a Will is called a codicil.
 A Will must meet legal and technical requirements.
 A Will must be kept in a safe and secure place.
 A Will must be in writing and executed according to state laws.
A Will should not be confused with “Living Wills” which are legal instruments which
state the individual’s desired as to the use of life-sustaining measures in case of
terminal illness or serious incapacitation.
TRUSTS
A description of all types and applications of trusts is outside the scope of this text, but
there are certain trusts that are common in estate planning, and a knowledge of how
these trusts apply is important in determining the value of life insurance in these areas.
BASIC TRUSTS
When a living person creates the trust and transfers property to it, the trust is an inter
vivos trust. Conversely, a trust created at death through a Will, is called a testamentary
trust.
A living trust (inter vivos) can be either revocable or irrevocable. With a revocable
trust, the grantor (the person creating the trust) can change or terminate a trust
whenever they wish. This is used, for example, to transfer property directly to
beneficiaries outside of the probate estate. There is no income, estate or gift tax
savings with a revocable trust.
With an irrevocable trust, the grantor gives up all rights of ownership or control over
the trust. While there can be a gift-taxable event using this type of trust, there could be
income and estate savings applicable to the property or cash.
Marital Trusts
The marital deduction of the Internal Revenue Code (IRC) provides f or an unlimited
deduction for property left to the surviving spouse, therefore everything can be left to
the surviving spouse and there would be no estate tax. However, upon the death of the
surviving spouse, the estate may be larger and more estate taxes may be due.
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The actual creation of a marital trust may be unnecessary, however it can be used for
investment management and administration purposes.
Qualified Terminable Interest Property trust (QTIP)
A property interest will usually not qualify for the marital deduction unless it is
included in the surviving spouse’s gross estate and certain terminable interest property
passing to a surviving spouse does not qualify for the marital deduction. However the
QTIP trust can qualify for the marital deduction.
The QTIP trust allows a decedent to provide for the surviving spouse during his/her
lifetime, but at the same time, it allows for the decedent to direct the transfer of
property to others without loss of the marital deduction. The main purpose of the Q TIP
trust is usually used to make sure that if, after the death of the first spouse, the
surviving spouse’s remarriage will not result in the children of the first marriage
receiving nothing from the estate.
Bypass Trust
A trust that is used for property that is not left to the surviving spouse in a QTIP trust,
or not used for other bequests, taxes or expenses, is put into a second trust, a bypass
trust) also known as a Credit Shelter trust, Nonmarital trust or Residuary trust).
Frequently, the surviving spouse has the right to the income for life from the bypass
trust. This allows the surviving spouse to use the decedent’s property during his/her
lifetime, without having the residual trust included in that spouse’s estate for federal
estate tax purposes.
Trust for Minor Children
A trust for periodic payments for the children’s education or other such use when they
are old enough to handle the responsibility of the fund, is often used. Previously, the
point was made that the annual exclusion is availabl e only for gifts of present interest.
Therefore, the annual exclusion would not be available for a gift for a minor in trust if
the funds were not available to the minor. This can be overcome using a Section
2503(c) trust which requires that the trustee has the discretion to distribute both
principal and income; the beneficiaries are entitled to receive the principal of the trust
when they reach age 21; and if any of the beneficiaries die before age 21, the child’s
share of the assets would pass through to his/her estate. By using this trust, the $10,000
annual gift exclusion can be used and income can be accumulated until the child reaches
age 21.
With this type of a trust, gifts of life insurance policies in trust for minors should
qualify as being of present interest if any policy value is used for their benefit. If the
ownership of the policy vests at age 21, the policy value or proceeds would be included
in the gross estate of the child if the child were to die prior to age 21.
Another way to make these gifts is to take advantage of the Uniform Transfers to
Minors Act, wherein an adult is named custodian for the minor child and manages the
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property, and distributes the property to the minor at age 21 (or 18, depending upon
state law).
Crummey Trust
The Crummy trust (named after the first person to successfully use this trust) allows the
annual exclusion to be available for gifts made to such a trust, provided the
beneficiary(s) have a reasonable opportunity to demand distribution of the amounts
contributed to the trust. The grantor makes a gift to the Crummey Trust, which is an
irrevocable, living trust, and usually the beneficiaries are the grantor’s children or
grandchildren. The beneficiary(s) are notified when property has been transferred to
the trust, and they are also notified that they have a period of time (such as 60 or 90
days) to withdraw some portion of the transferred property. The fact that the
beneficiary(s) has been given notice of the right to withdraw property at the same time
that the property is transferred to the trust, is in effect, giving the property to the
beneficiary(s) outright, and thus, qualifying for the $10,000 annual exclusion.
Rarely, if ever, will the beneficiary(s) withdraw any funds, and after a short period
(stated in the trust) of time, the beneficiary(s) powers lapse. According to law, a lapse
will not be treated as a taxable gift from each beneficiary to all other beneficiaries,
provided the amount is $5,000 or less.
IRREVOCABLE LIFE INSURANCE TRUSTS
The value of a life insurance policy for gift tax purposes, is the interpolated terminal
reserve (definitely an actuarial calculation) plus any unearned premium, instead of the
policy face amount, making it a very popular method of saving taxes. (What this me ans
is that the reserves plus unearned premium is less than the face amount). Under the
Irrevocable Life Insurance Trust (ILIT), an insurance policy on the life of the grantor is
owned by the irrevocable living trust. If the grantor lives for more than 3 years after
the trust has been established (so that “anticipation of death” is not considered), since
all incidents of ownership are relinquished, the policy proceeds would not be part of the
grantor’s taxable estate.
If the policy was purchased by the trustee and at the discretion of the trustee, the threeyear waiting period is not required. The premiums are paid by the trustee either from
the trust funds, or directly from the grantor.
By using this trust, death proceeds can be invested or distributed to trust beneficiaries
by methods not available under life insurance settlement options, therefore the proceeds
are usually paid in a lump sum and the trustee is responsible for the disbursement of the
proceeds according to requirements established by the grantor prior to his death.
Also, by using a life insurance trust instead of a gift of life insurance outright, the
$10,000 annual exclusion can be made for the policy, as well as for premiums paid on
the policy by the donor. However, if the policy has been assigned to the trust, or when
the premiums are paid on policies in the trust, the $10,000 annual exclusion may not be
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available unless a Crummey provision is part of the trust agreement. Therefore, the gift
of a policy in trust and future premium payments can be fully taxable gifts that are later
added back to estate for estate tax purposes. There is no income tax savings if the
policy insured either the donor or his/her spouse.
Charitable Remainder Trusts
A Charitable Remainder Trust (CRT) is a living and irrevocable, tax-exempt trust
whereby the donor gives property to a charity, but reserves an income stream from the
trust to himself (or someone else), with the residual trust amount (trust corpus), also
called remainder interest, passed to a charity. The CRT is an excellent method of
helping a charity and at the same time, save on transfer taxes.
There are two types of CRT’s. The charitable remainder annuity trust (CRAT), pays a
fixed amount to the income beneficiary at least annually. The am ount is not changed
during the lifetime of the trust and no additional assets may be contributed to a CRAT.
The charitable remainder unitrust (CRUT) pays a certain, fixed percentage of the fair
market value of its assets to the income beneficiary, minimum annually. The assets of
the trust are valued each year, so the income will vary accordingly. Additional
contributions can be made to a CRUT.
CONSUMER APPLICATION
Ozzie wants to leave most of his assets to his church, Wesley Methodist, but he needs
money to live on so he does not want to make a charitable contribution to the church at
this time. Therefore, he establishes a charitable remainder trust, with Wesley as the
beneficiary, but Ozzie would get income from the corpus each year. Ozzie has other
assets tied to the stock market, so he has income the is pretty much inflation -free.
Therefore, he elects a CRAT which would pay him a steady income, regardless of the
market.
Using Life Insurance with CRT
Since, under a CRT, the grantor gives up the ownership and control of the property that
is transferred to the CRT, while the CRT saves estate taxes, the heirs lose the value of
the property, which is a disadvantage to many. Therefore, by establishing an
irrevocable life insurance trust, with death benefits approximately equal to the value of
the property that is transferred to the CRT, this problem can be solved. The premiums
for the policy should be considerably below the income from the trust. If it is
“structured” properly, the death benefits proceeds will not be included in the grantor’s
gross estate.
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USING TRUSTS UNDER EGTRRA 2001
It is interesting to review various approaches used by financial and estate planners since
the law was enacted. It is quite evident that there has been a lot of thou ght gone into
any recommendations as to how to approach estate planning by building on what has
worked in the past, and still plan for more fluidity that was ever necessary before.
Using a family trust seems to be a “given” but with certain peculiarities to apply for
different situations as they arise.
The trusts should be “grantor” trusts (where an individual places their own assets into
the trust) and therefore any trust tax would not be applicable, or at the least, neutral.
The trust should be set up so that it has a bypass provision (i.e. a trust which removes
the assets from a surviving spouse’s estate, thereby excluding such assets from Federal
Estate Tax upon the death or the surviving spouse). In effect, when the first spouse
dies, the trustee can set up a new, irrevocable trust funded by either the decedent’s
assets, or a sum of money that equals the assets. These assets would then be exempt
from estate taxes and a step-up in basis, up to whatever the maximum is in the year that
the deceased spouse dies. If this date is prior to 2010, there would be no federal estate
taxes, and the step-up basis would be limited to $1.3 million. After 2010 there would
be no federal estate taxes (assuming the law remains basically the same) and the step up basis would also be at $1.3 million. In either event, there would be state death taxes
in some amount, probably.
The trust should probably also have a Qualified Terminable Interest Property Trust (Q TIP) (also called a “C” Trust) provision, which would allows the trustee to set up a new
irrevocable trust to hold all, or some, of the decedent’s assets and these assets would
not be included in the decedent’s taxable estate, but will be in the surviving spouse’s
estate. Therefore, there are no estate taxes on the assets in the decedent’s estate, but are
deemed to be in the surviving spouse’s estate. It makes no difference if the first spouse
dies before or after 2010 because there will be no estate taxes on these assets as they
are protected by being in the surviving spouse’s estate. However, if the first spouse
dies in 2010 or later, the amount in this trust will get a step -up in basis of up to $3
million because assets have been technically transferred to the surviving spouse.
The trustee should be given a lot of flexibility at the death of the first-to-die spouse,
which will allow the trust to fund the trust – either the Q-TIP or Bypass – so as to
achieve the minimum taxation from the state and federal governments.
It has been pointed out by knowledgable professional estate planners that before this
2001 act, the By-pass provision would have been in the trust with specific instructions
as to how much and when to place the assets into the trust. But with the complicated
law with so many variables, it is not possible to determine with any degree of accuracy,
exactly what is the best planning strategy. It could be that one could have either (or
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both) a capital gains tax because of a step-up in basis, and an estate tax problem. This
leaves three choices:
1. Fund only the By-pass trust.
2. Fund only the Q-TIP trust.
3. Fund both the By-pass and the Q-TIP trusts.
Which choice will result in the least taxes? There is no way to know until one of the
spouse’s dies. Therefore, the estate planner must plan for several cont ingencies, which
could be more expensive to the estate owner because of the creation of trusts, which
will be more complicated and more difficult to function properly after the death of the
first spouse.
Capital gains tax must be considered if the basis is substantial, particularly if it also
considers the personal residence, but if there is little concern about capital gains taxes,
the trust could be established with only the By-pass trust provision. (Refer to the
section on the By-pass trust earlier described).
A different estate planning problem arises if the estate is quite large and the exemption
of $1.3 million of $3 million step-ups in basis would not apply. Then the vehicle of life
insurance, in particular, would apply quite well. The death be nefit of the life insurance
policy would provide the cash to pay the capital gains tax.
REVIEW EXISTING ESTATE PLAN
If the owner of the estate expects the estate to be worth at least $1 million by 2010 (or
$2 million if married) or will be dead before that date, it would be an excellent idea to
completely review the existing plans in view of the changes in the tax laws. When the
estate owner estimates the worth of the estate – now and later – everything should be
considered, including any assets he/she is liable to inherit, the amounts in pension
plans, and even the value of the death benefit of the life insurance policies.
The principal provisions that one should look for, are those that pertain to flexibility.
The heirs or trustees must be able to take advantage of these new exceptions, the stepup in basis and the lower tax rates. Add to that the fact that no one knows what the tax
laws will be when death strikes, and the importance of a good estate planner has gained
considerably because of the new tax laws.
As time goes on, there will be many bright, professional estate planners, who will fine tune the estate planning process to take advantage of not only the new tax laws, but also
be prepared for changes which will inevitability occur. In the p olitical climate of the
next few years where there is and will be more balance between the political parties in
Washington, changing (“tinkering” or “improving” the tax act, depending upon which
political party is doing the changing…) is almost a certainty.
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THE EFFECT OF THE EXPIRATION PROVISION
What will happen if and when the act ceases to exist, is anybody’s guess. It is doubtful
that the act will simply die, as there would be chaos as the courts, the government and
regulatory bodies – federal and state – and the Internal Revenue Service should try to
agree on what law was in effect. So will congress simply take the high road and simply
extend it as it is? Given the history of most laws, particularly as complicated as this
act, it will demand some changes along the way. “Fine-tuning” is what Congress call it.
Nothing that the estate planner can anticipate in the planning process can be relied upon
to be completely valid in the near future. This means that estates worth more than $1
million (per person) will need to have their plan reassessed every 2 or 3 years – or at
least until there is a modicum of stability in the system so the process of long -term
planning will be legitimate.
THE EFFECT OF DYING UNDER THE TAX ACT
For those who will probably not live past the year 2009, the process of estate planning
for the various death taxes, should remain about the same as they have been for several
years. Some amount of federal estate taxes will be paid by the estates through 2009, as
well as state death taxes. In addition, the full step-up in basis will still be around
through 2009, lending a stabilizing effect to typical estate planning.
Now comes the “iffy” part. It is fair to say that the earlier that the owner of an estate
dies during the period between 2001 and 2009, the more likely it is that the estate will
have to pay estate taxes, and the higher that rate will be. If, for example, the client has
a short life expectancy, certain techniques will need to be applied to mitigate the effects
of the estate taxes. These techniques will include, but is not limited to, family and
QTIP trusts for married couples; irrevocable life insurance trusts to provide tax -free
benefits to pay these estate taxes (just like today); using gifts, either the annual
exclusion or the unified gift tax credit; annuities, which frequently reduce the size of
the taxable estate; and of course, charitable giving, before the estate owner dies and
after they die.
It really comes down to planning an estate, with the major cha nge in death tax planning
depending upon what the tax rate is when an individual dies. Who is to say that a
younger person will live beyond 2010 when major changes in estate taxes will occur, or
at a point between now and then, when the tax rates and excl usions are different.
It must be remembered in estate planning, that even if the federal estate taxes expire in
2010, the step-up in basis will be partially lost, which will mean that capital gains taxes
will be paid by heirs of estates as the larger estates shift from estate taxes to capital
gains taxes under this 2001 act. Then with the likelihood that states will increase rates
or reduce exemptions, will just add to the conclusion that it is necessary to create very
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flexible plans for many people and these plans will be quite a bit more complicated that
what was necessary in the past.
THE ROLE OF LIFE INSURANCE WITH THE TAX ACT
At least for another 8 years, life insurance will continue to be the most effective way of
providing funds to pay estate taxes. But now the problem is that the ownership of life
insurance must be structured so that at the death of the insured estate owner, the life
insurance proceeds will not be subject to estate tax. This continues to be the primary
reason to use life insurance in estate planning.
If the estate tax is eliminated during the lifetime of the insured, then the game has
changed. If the estate tax is eliminated, the benefit of the life insurance policy will be
to provide the insured with lifetime income-tax free access to the cash value that can be
used for other purposes.
There are several methods that help to solve the problem of accumulating funds
available from life insurance, if they are not needed to pay estate taxes. At this time,
because of the complexity and newness of the tax code changes, these methods are not
widely known. One example is that described in the following Consumer Application.
CONSUMER APPLICATION
Louis had an estate plan established, with provisions for a life insurance policy to pay
the estate taxes. With the introduction of the 2001 tax laws, he became concerned as to
what would happen if he survived to year 2010 and the policy proceeds were not needed
as there would be no estate taxes. His estate planner and attorney suggeste d that he
establish an irrevocable trust that would (1) remove from his taxable estate, the policy
proceeds when he died, and at the same time, (2) Louis would have access to the cash
values of the policy, income-tax free, during his lifetime.
The trustee has the authority to make loans or withdrawals to the insured using the tax free proceeds from the policy.
The trust has the provision that the trust is terminated if the present federal estate tax is
repealed.
NOTE: The establishment of a trust such as that illustrated in the above Consumers
Application would require the services of an attorney. The trust as described above was
developed by a tax attorney who has a copyright on that particular trust so details as to
how this trust can be developed cannot be described in this text and is presented for
illustrative purposesd only.
Irrevocable life insurance trusts are certainly nothing new, however with the new tax
act, starting in 2010 (unless the IRS makes an adverse ruling in the meantime) a transfe r
of money or property to a trust will be treated as a taxable gift UNLESS the trust is
treated as wholly owned by the donor of the trust (or donor’s spouse) under the grantor
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trust provisions of the IRS Code. According to some tax specialists, this rule will
stand, even if there are withdrawal powers in the “Crummey” trust. Whether this is a
way that the IRS can finally do away with the Crummey trust, or not, the point remains
that this area needs to be scrutinized by a good tax attorney if the Crummey trust is an
important part of an existing estate plan.
This new provision can obviously affect transfers of cash to be used to pay insurance
premiums, to an irrevocable trust – unless the trust is treated as only by the donor (or
donor’s spouse) under the provision of the IRS code. This law should be kept in mind
when drafting any irrevocable insurance trusts.
APPLICATION OF STEP-UP IN BASIS AFTER 2010
The $1.3 million as a step-up in basis (for single persons) who die - using discount rate
of 7%, that would equate to $660,000 in total basis in today’s dollars - is the available
step-up to members of the family heirs after the parent’s death. Therefore, when
stocks, real estate and other assets are liquidated by the family member heirs after 2009,
obviously there may be considerable federal capital gains taxes, not to mention state
income taxes, that are due and payable.
Considering life insurance because of its unique income tax situation during the lifetime
of the insured and after death, should still be an important arrow in the quiver of the
estate planner, as the income-tax free distribution during lifetime and at death will
continue. Therefore cash value life insurance will be indispensable in avoiding the
financial strain of federal capital gains taxes and state income taxes, regardless. The
net gain in the value of life insurance when related to other and taxable forms of
investing, will be approximately 25%, or to be more accurate, the total of the federal
capital gains tax rate, plus the state income tax rate (if any).
It is probable that because of the income tax basis step-up at death, the charitable
remainder annuity trusts and unitrusts (CRAT & CRUT, discussed earlier) that are
funded with securities or other assets that are highly appreciated in value, will be used
in order to avoid the capital gains taxes when these assets are sold. So, as the
charitable remainder trusts become more popular, the life insurance vehicle should
become more popular as a means to replace wealth.
In particular, after the estate tax is repealed, the life insurance policy is a great vehicle
to be used to replace the wealth of the family. When a charitable remainder trust is
used to create these income tax advantages, the family heirs will no longer benefit fr om
the (current) estate tax law savings, which can amount to as much as 55% (when the
charitable trust assets pass to the designated charity at the death of the trust donor or
donor’s spouse).
For example, at the present time, if a donor dies and leaves a substantial estate, for
every dollar that the donor leaves to the family, (if the estate is in the 55% estate tax
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bracket), elementary arithmetic shows that there is only 45 cents left for the family.
Therefore, every dollar left to a charity would cost the family only 45 cents. The 45
cents is what is needed to be replaced by life insurance.
When (if) the federal estate tax is repealed, it will cost the family a dollar for every
dollar left to charity because the family will receive no estate tax be nefit as a result of
the charitable gift, therefore a dollar of life insurance is needed to replace the dollar
that goes to the charity.
INCOME IN RESPECT TO A DECEDENT
The Income in Respect to a Decedent (IRD) deduction enables the recipient(s) to dedu ct
certain IRD items, such as benefits paid under qualified retirement plans and taxable
IRAs which are subjected to both estate tax and after income tax following the owner’
death. If the federal estate tax is eliminated, this deduction will also be eli minated. If,
for instance, the estate was in the 55% bracket and if the IRD recipient was in the 45%
marginal income tax bracket (both state and federal) the benefit of the IRD would be
approximately 25% (45% x 55% = 24.75% to be exact).
The result of the estate tax repeal would, therefore, mean that proceeds of an IRA or
other IRD benefits would be fully subject to ordinary income tax, even if the IRA assets
would have been eligible for capital gain tax rate treatment if the assets would be held
outside the IRA – which may exceed 40%.
In summary, assuming that life insurance policy proceeds will always be exempt from
income tax, there is no need for any IRD deductions of the proceeds. The recipients of
IRD items, such as IRA distribution, will be subject to ordinary income tax under the
new law and will, therefore, lose the income tax deduction which presently is worth up
to 25%.
SUMMARY OF BENEFITS OF LIFE INSURANCE FOR PLANNING
It would be hard to argue against using life insurance for estate plan ning today, and
even if the estate tax is repealed after 10 years, life insurance will still be a very
valuable source of liquid funds. For maximum flexibility, irrevocable trusts which are
designed to remove life insurance proceeds from the taxable estat e will allow the
insured to take advantage of the income-tax free cash values if the policy is not needed
to pay estate taxes, and will provide income-tax free proceeds for any purpose.
When (and if) the estate tax repeal actually happens as planned, beca use of the new
carryover income tax basis rule, the insured (and family) will benefit from the tax
advantages offered by life insurance. In addition, as indicated earlier, they will benefit
from the income tax advantages of life insurance as a result of t he repeal of the income
tax deduction for estate taxes paid on income in respect of a decedent (IRD).
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STUDY QUESTIONS
Chapter 7
1.
2.
3.
4.
5.
6.
Life Insurance
A.
is not used by Financial Planners.
B.
is never used in retirement planning.
C.
plays an important role in estate planning.
One of the basic objectives looked at by a financial planner is
A.
cash objectives.
B.
what color car the client wishes to purchase.
C.
how to avoid income taxes.
Estate planning is concerned with
A.
the accumulation of wealth to be used in retirement.
B.
maintaining the standard of living.
C.
with the distribution of property at death.
A person who dies without a Will
A.
dies testate.
B.
dies intestate.
C.
leaves his/her property to the state.
A “living will”
A.
is one that has been changed.
B.
leaves all property to a spouse tax-free.
C.
is a legal instrument, which states an individual’s desires as to the use of life
sustaining measures.
When a living person creates a Trust and transfers property to,
A.
it is an inter vivos trust.
B.
it is known as testamentary trust.
C.
the property must be real estate.
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7.
8.
9.
10.
11.
12.
With a revocable trust
A.
the grantor cannot change the trust.
B.
the grantor can change the trust.
C.
only the beneficiary can change the trust.
__________________ provision of the Internal Revenue Code allows for an unlimited
deduction for property left to the surviving spouse.
A.
A business deduction.
B.
The life insurance deduction.
C.
The marital deduction.
A living and irrevocable trust, wherein the donor gives property to a charity but receives
income from the property for life, is called a
A.
Crummey trust.
B.
Bypass trust.
C.
Charitable Remainder trust.
At least until the year 2010, _________________, will continue to be the most effective
way of providing funds to pay estate taxes.
A.
the marital deduction.
B.
the gift tax exclusion.
C.
life insurance.
A Will gives the maker the opportunity to
A.
name an executor.
B.
avoid probate.
C.
change the “beneficiary” on a life insurance policy.
The grantor of a trust
A.
cannot be the trustee.
B.
can charge beneficiaries, if the trust is revocable.
C.
can avoid estate taxes, by using a revocable trust.
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13.
14.
15.
The Economic Growth and Tax Relief Reconciliation Act 2001 (EGTRRA)
A.
eliminates income taxes in the year 2010.
B.
reduces the Gift Tax Rate to 35% in the year 2010.
C.
increases the Federal Estate Tax Rate and reduced the Federal Gift Tax Rate in
the year 2010.
Life insurance is usually purchased
A.
with a lump sum.
B.
to evade income taxes.
C.
to replace income lost by the death of the wage earner.
Estate Planning deals with
A.
the distribution of an individual’s property at death.
B.
maintain a standard of living.
C.
the accumulation of wealth through investing.
Answers to Chapter Seven Study Questions
1C 2A 3C 4B 5C 6A 7B 8C 9C 10C
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11A 12B
13B
14C
15A
CHAPTER EIGHT - BUSINESS USES OF LIFE INSURANCE
Even though life insurance is generally purchased for personal or family purposes, it
also fills a very important need of the business and industry community. This is an area
requiring considerable expertise and there are very successful agents, brokers and
insurance companies that specialize in this market. It is not an easy market to
penetrate, as accountants and attorneys, in addition to senior officers of corporations,
become involved in this process. Using life insurance for business purposes is technical
and requires expertise, but those who are seriously involved in this importa nt market
started “small”, such as with small businesses, and then as confidence and expertise
grew, expanded into the larger firms.
Business uses of life insurance can be categorized into three areas:
1. Business continuation
2. Key employee
3. Nonqualified executive benefits.
BUSINESS CONTINUATION
CLOSELY HELD FIRMS
Almost 20% of the assets of the households in the U.S. are held in businesses that are
privately held, and in most cases, family businesses. These are considered as closely
held businesses. These businesses have unique characteristics, such as that the owners
usually manage the firm and are usually owned by less than 10 individuals.
For purposes of this discussion, the most important characteristic is that the ownership
of the closely held business is usually not marketable. Therefore, the only ones who
would be interested in purchasing the business upon the death of the principal would be
other owners, employees, or competitors. In any event, the successor(s) could have a
difficult time keeping the business going as lines of credit would have to be re established, and the ‘very important but difficult-to-measure asset’ of “good will” may
be dissolved or decreased by the death of the original owner.
The business stability and the continuation of the business following the death of the
owner, or one of the owners, of a closely held corporation are highly important to the
family of the deceased owner and the surviving owners, not to mention the employees.
The principal types of closely held firms are
1. Sole Proprietorships,
2. Partnership, &
3. Closely-held Corporations.
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SOLE PROPRIETORSHIPS
As the name implies, a Sole Proprietorship is an (unincorporated) business owned by a
single person; typically the owner also manages the business. The fact that it is owned
and operated by a single person makes it a particularly “fragile” business because
everything revolves around the owner.
When a proprietor dies, the debts of the business become the debts of the estate as the
law recognizes business and personal assets as one and the same in a sole
proprietorship. The personal representative, or executor, of the proprietor is required to
dispose of the business as quickly as possible.
Life insurance can fund the disposition in several ways:
 If the business is transferred through a Will, the life insurance’s death benefit can be
applied to satisfy the proprietor’s personal debts, business debts and estate taxes.
 If the executor or personal representative conducts a liquidation of the business, a
death benefit of a life insurance policy can be used to reduce or eliminate any debt.
This money can also be used as a source of working capital for interim financing to
operate the business for a short period of time.
 If the business is to be transferred to an employee, or a child, the insurance funds
can be used to finance the transfer.
 If the business is to be sold to a key employee through a buy-and-sell agreement
(discussed later), the key employee usually has previously bought a life insurance
policy on the sole proprietor and made the premium payments. The buy-and-sell
agreement stipulates the formula to be used in valuing the business as well as other
conditions of the sale. Upon the death of the proprietor and the sale of the business
to the key employee(s), the proprietor’s estate receives the cash amount according to
the buy-and-sell agreement, and the key employee(s) receives the deceased
proprietor’s business.
PARTNERSHIPS
A partnership is a voluntary association of two or more individuals for the purpose o f
conducting a business for profit as co-owners. There are two basic kinds of
partnerships, (1) General partnership, where each partner is actively involved in the
business and each are liable for the partnership obligations; and (2) Limited partnership
has one (or more) general partners, and one or more limited partners who are not
involved in the management and are liable for obligations of the partnership only to the
extent of their investment in the partnership.
The most important rule of partnership law affecting the area of life insurance is:
 upon the death of a general partner, the partnership is dissolved, and in the absence
of contrary arrangements, the surviving partners become liquidating trustees.
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The surviving partners must not only liquidate the business; they also must pay to the
estate of the deceased, a “fair” share of the liquidated business. Unfortunately,
liquidation of a business nearly always results in the assets of the business shrinking as
most of the assets will only bring a portion of the actual value. Most importantly to the
survivors, is the method of making a living has just disappeared.
CONSUMER APPLICATION
Olivia Kern and Elaine O'Connell were co-owners of a successful 10-year-old retail
business. When Elaine was tragically killed in a car accident, Olivia suffere d a double
loss: first, the death of her dear friend and second, the loss of her business. Why her
business? While Elaine's husband and daughter both wanted Elaine's business to
continue after her death, they were forced, for financial reasons, to use Ela ine's share of
the business income, causing the store to close.
Neither of Elaine's survivors were equipped to contribute financially to the business nor
were they equipped by training or personality to help run the business. Seeing the
financial problems her friend's family was having, Olivia immediately began sharing
profits with them and attempting to add to that amount to buy Elaine's half of the
business from her heirs. These kind and thoughtful actions unfortunately resulted in
cash flow problems for the business and finally, the financial burden forced Olivia to go
out of business altogether. Olivia's loss was rooted in the lack of capital to purchase
Elaine's half ownership from the survivors when Elaine died
Often, partners believe that if one partner dies, the surviving partner will simply buy
out the interests of the estate. This is overly-simplistic because the surviving partner
will have to come up with the money, and even if that is possible, they must pay a fair
price. This brings up another problem, which is that the surviving partner has a
fiduciary relationship with the estate of the deceased and other surviving partners (if
any), and in some states, they are not allowed to purchase the property because it
amounts to a “trustee purchasing trust property.”
BUY-AND-SELL AGREEMENTS
Because of the reasons as listed above, it is very common for partnerships to enter into
a buy-and-sell agreement. This type of arrangement has been mentioned earlier, and
can be used for sole partnerships, partnerships and close corporations in which the
business interests of a deceased or disabled proprietor, partner or shareholder are sold,
according to a predetermined formula to the remaining members of the business.
As an example, for a business with three partners, the agreement could be that upon the
death of one partner, the two survivors agree to purchase, and the deceased’s partner’s
estate has agreed to sell the interest of that partner, according to a predetermined
formula for valuing the partnership, to the survivors. The funds for buying out the
deceased partner’s interest are usually provided by life insurance policies, with each
partner purchasing a policy on the other partner(s). Each is the owner and beneficiary
of the policies purchased on the other person.
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For a “professional partnership” – usually for attorneys and physicians – the business
continuation agreement is a little different. There is usually a provision whereby the
income to the deceased partner’s estate or heirs continue for a specified period of time,
and with the amount of the income based on a profit -sharing agreement. Frequently,
there is also a separate agreement providing for the sale of the deceased partner’s
business assets.
There are two types of buy-and-sell agreements, entity and cross purchase.
Under the entity type of buy-and-sell agreement, the business itself is obligated to buy
out the ownership of a deceased (or disabled) partner, with each partner binding his/her
estate to sell if the partner is the first to die.
Under the cross-purchase agreement, the agreement is between the business owners
themselves as each owner binds his/her estate to sell his/her business interests to the
surviving owners; and each surviving owner binds himself/herself to buy the inte rest of
the deceased owner.
As indicated above, life insurance is commonly used to fund these arrangements.
Entity Approach
Under the entity approach, the partnership itself applies for, owns and is the beneficiary
on each partner’s life. The death benefit of the policy should, in most cases, equal the
value of the insured partner’s interest in the business.
Cross-purchase Approach
Under the cross-purchase approach, each partner applies for, owns and is beneficiary of
a life insurance policy on each of the other business partners. The death benefits
generally equal the agreed-upon value of the other partners’ interest in the business.
TAXATION OF PARTNERSHIP BUY-AND-SELL AGREEMENTS
The taxation of life insurance proceeds used for partnership buy-and-sell agreements, is
the same as individual personal insurance. Premiums are not deductible as a business
expense, whether it was paid by the business or a partner. Death proceeds are normally
income tax free.
 The cost basis for each surviving partner is increased by the proceeds received by
the partnership in the case of the entity plan; and by the amount paid for the
deceased partner’s interest under the cross-purchase plan.
Life insurance death proceeds are not included in the gross estate of the insured unless
the insured possesses any incidents of ownership in the policy, or the proceeds are
payable, to or for the benefit of, the insured’s estate. Any death proceeds payable to the
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partnership normally would increase the value of the partnership for estate tax
purposes.
The question of valuation of the business for estate tax purposes must be addressed if
the value of the business is less than fair market value even if there is a value stated in
the agreement. A value stated in the agreement will control if the agreement is a bona
fide business transaction performed at “arm’s length” and is not a method of
transferring property to the deceased’s family for less than adequate compensation.
CLOSELY HELD CORPORATIONS
A closely held corporation is usually held by a small number of people active in the
business, and usually is not sold or transferred except for death or disability, or in case
of major corporate restructuring. The difficulties involved when a shareholder dies are
caused because of the very structure, i.e., the shareholders are usually its officers, they
have an incentive to pay themselves salaries (salaries are tax deductible, dividends are
not), and the BIG problem: there is no market for their stock.
It will be noted that there is a significant similarity to a partnership situation, therefore
a plan to retire a stockholder’s shares in case of death can be as important to
shareholders, as for the owners of a sole proprietorship or partnership .
Death of a Majority Stockholder
A unique situation arises when the majority stockholder in a closely -held corporation
dies (or is disabled). Many closed corporations (synonymous with closely-held
corporation) are family owned with a principal stockholder, or the founder of the
company, etc., is a majority stockholder. When this stockholder dies, the other
stockholders may have to accept an adult heir into the company (everyone is aware of
the hazards involved in a new majority stockholder), or perhaps they may have to pay
dividends to the heir(s) which would be approximately the same as the salary of the
majority stockholder had been receiving. If the stock of the deceased stockholder has
been sold to an outside interest, the remaining stockholders may be forced to accept
active management of someone they, at the very least, did not know.
The only other alternative would be for the remaining stockholders to purchase the
stock from the estate of the deceased stockholder. This may be impractical as th e
remaining stockholders may not have sufficient funds to purchase the stock, they may
not be able to agree on a fair price, and sometimes the heirs will refuse to sell.
The alternatives to the heirs are not encouraging, and as a practical matter, the bes t they
can hope for in most cases, is a reasonable percentage of the worth of the business. The
remaining stockholders could possibly get what they can from their stock, and then take
their talent and customers and start up a new business.
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Death of a Minority Stockholder
The death of a minority stockholder, or an equal stockholder (where everyone has the
same percentage of shares) have serious problems also. The majority stockholders can
force their will on the new minority stockholders, and at the ver y best, lawsuits can
start flying all over the place – there are a lot of laws protecting minority stockholders.
All this being said, the fact still remains that the minority stockholder’s heirs are not in
a good situation as they own stock which was possibly subject to rather substantial state
and federal estate taxes, but the stock has little, if any, marketability, as who would buy
a minority interest in a closely-held corporation? Further, they will not receive any
income from the stock as closed corporations rarely pay dividends (stockholders prefer
salary).
CORPORATE BUY-AND-SELL AGREEMENTS
The entity (usually stock-redemption) or the cross-purchase agreements will work as
well for close corporations as for partnerships. It would be repetitious to go through
the procedures again, but it would be more important to have a frequent valuation of the
stock and the agreement reviewed and changed when necessary.
Using life insurance, each stockholder is insured for the value of the stock that they
own, and the insurance is either owned by the stockholders or the corporation. Upon
the death of the stockholder, benefits are used by either the stockholders or the
corporation, and the business future of the survivors continues and the beneficiaries of
the estate receive cash for their interest.
Taxation of Corporate Buy-and-Sell Agreements
Life insurance premiums are not tax deductible with the stock redemption or the cross purchase approach and proceeds are not taxable (except in some Minimum Tax
situations). Increase in cash values are usually not taxable.
If life insurance is owned by a corporation to fund an entity buy-out agreement and then
at a later date it is decided to change to a cross-purchase agreement, the policies that
are owned by the corporation can not be transferred directly to the shareholder
(someone other than the insured) or the “transfer-for-value” rule may apply. This rule
allows exceptions for transfers between partners and partnerships, but not between
corporations to stockholders. It has sometimes been suggested that the stockholders
also enter into a (side) partnership agreement because a transfer for value does not
apply to partnerships.
As with the partnership entity buy-and-sell agreements, the life insurance death benefits
will not be included in the estate of a deceased stockholder (unless the stockholder had
an incident of ownership in the policy or if the benefits were paid to or for the
stockholder’s estate).
145
A full discussion of the Alternative minimum Tax (AMT) is outsi de the scope of this
text, but it should be mentioned that with most modern cash -value policies, after a few
years the annual increase in the cash value exceeds the net annual premium. In some
cases this would trigger the AMT tax. If there is a possibili ty of this, the crosspurchase approach should be considered as the corporation is neither the owner or the
beneficiary of the policies and the AMT tax could be avoided.
NOTE: At the time this text was being prepared, Congress was seriously debating the
repeal of the alternative minimum tax and while it will probably be passed in the House,
the Senate may or may not pass it at this time. If this tax is repealed, references to this
tax should just be ignored as a factor in this discussion.
CROSS-PURCHASE vs. STOCK REDEMPTION AGREEMENTS
TAXATION
In determining the best type of agreement for tax purposes, it would depend upon the
tax status of the corporation and the shareholders. If the corporation is in a lower tax
bracket, the redemption plan would be best in most cases as the premium payments for
the policies would take a smaller share of the corporation’s after-tax income, than it
would take of the shareholders’ after-tax income.
However, if the shareholders are in a lower tax bracket, the cross -purchase plan may be
better because the premium payments would take less of the after -tax income of the
shareholder than that of the corporation.
With only two shareholders, there is little administrative difference in the two plans.
However, if there are several shareholders, each shareholder would have to purchase a
policy on each of the other shareholder’s lives. (To determine the number of policies
that would be required, the formula is n(n-1) where “n” is the number of stockholders.
If there were 6 stockholders, then 6(5) – or six, times [six less one =, or five] – would
be 30 policies that would be needed).
For tax purposes, with a stock-redemption plan, when the corporation buys the stock
from the heir or estate of the deceased stockholder, the stock then becomes treasury
stock and is no longer outstanding. The other stockholders now own a larger
percentage of the shares outstanding, even though they maintain their original stock
with no increase in cost basis – and even though they now each own a larger share of
the corporation. However, as the ownership has increased and the cost basis remained
the same, upon a subsequent sale, their taxable gain will have been increased.
Under a cross-purchase plan, the remaining stockholders purchase the stock with their
own money so they acquire an increase in basis that is equal to the purchase price of the
new shares. Upon a subsequent sale, this new basis reduces the amount of any taxable
gain realized by the selling shareholder.
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These differences are important only if the stock is to be sold during their lifetime.
Otherwise, at death the stock will have a stepped-up cost basis, so the net effect would
be the same whether the ownership interest had increased by cross -purchase or entity
agreements.
CONSUMER APPLICATION
COMPARISON OF TAX CONSEQUENCES OF
CROSS-PURCHASE AND STOCK-REDEMPTION PLANS
SITUATION: The Handi Corporation is owned by Jim, Bob and Ray in equal shares.
Each stockholder originally put in $100,000 – their cost basis.
The fair market value of Handi Corp. is $1,500,000.
Each owner is insured under a life insurance policy for the value of their interest, $500,000.
Jim is the first to die, and under the business continuation agreement, Bob and Ray each now own
½ of the corporation ($750,000 each).
Bob retires, and sells his shares to Ray.
EFFECTS OF THE STOCK-REDEMPTION PLAN
Jim’s death:
The corporation collects $500,000 and redeems his stock.
The value of the business remains at $1,500,000.
Bob and Ray’s ownership value now is $750,000 ea ch, each cost basis remains at $100,000.
Bob retires:
Bob has a living buyout when he sells his ownership to Ray.
Bob has a capital gain of $650,000 ($750,000 less cost $100,000)
If capital gains tax is 20%, taxes of $130,000 would be due on $650,000 gain
Bob would realize net of $520,000.
EFFECTS OF CROSS-PURCHASE PLAN
Jim’s death:
Bob and Ray each collect $250,000 from life insurance policy, and buy Jim’s stock from his estate.
The value of the business remains at $1,500,000.
Bob’s and Ray’s interest (each) in ownership is $750,000.
Bob’s and Ray’s cost basis is $250,000 (insurance proceeds) plus original base $100,000 = $350,000
each.
Bob retires:
Bob has a living buyout when he sells his ownership to Ray.
Bob has a capital gain of $400,000 ($750,0 00 (sale price) less $350,000 cost basis)
If capital gains tax is 20%, taxes of $80,000 would be due on gain of $400,000.
Bob would realize net of $320,000.
(Note: If Bob retained stock until his death, the stock would then have a stepped -up basis to its then
fair market value on the death of the stockholder, therefore, the result would have been the same under
either method,)
STOCK REDEMPTIONS UNDER SECTION 303
Because many estates have large percentages in closely held businesses, they have
liquidity problems resulting many times in forced sales and in some cases, liquidation
of the business. The Internal Revenue Code 303 was created to alleviate this problem.
147
It allows qualifying estates income-tax free stock redemption, in an amount to cover
federal and state estate taxes, funeral expenses and estate administration expenses.
Since a partial redemption of stock is treated as a taxable dividend to the shareholder
that redeems the stock (or his heirs), this is very important in these situations. To
qualify, the stock value must be included in the gross estate of the decedent and the
value must represent more than 35% of the adjusted gross estate. The redemption must
be made within 3 years and 90 days of filing the estate tax return.
Life insurance is an excellent funding vehicle for these situations. The business applies
for and pays the premiums on the policies insuring the owner’s life. The insured is the
shareholder; both the policyowner and beneficiary is the business. At death of the
shareholder, proceeds are paid to the business. The results are very much like that of
key employee insurance.
MISCELLANEOUS CONCERNS
 The IRS imposes a 28% additional tax on a corporation that accumulates earnings
and profits beyond that which is needed for legitimate business purposes. The
cross-purchase plan avoids the accumulated earnings concern as the policies are not
owned by the corporation.
 Under a stock-redemption plan, since the corporation is the owner and beneficiary of
the life insurance proceeds, cash values and death proceeds are subject to attachment
by the creditors of the corporation as the policy values are considered as corporate
assets. This problem does not exist under a cross-purchase plan.
 Many states require that any stock redemption be made from corporate surplus funds
only. This problem does not exist under cross-purchase buyouts. Insurance
proceeds can alleviate the problem under a stock-redemption plan.
 If a company operates heavily on credit, as many do, it is important to notic e if the
loan agreement(s) has a restriction prohibiting stock redemption without the bank’s
prior consent. If it does, a stock-redemption agreement could fail unless it were
fully funded so that the creditors would not object to the redemption. This wou ld
not be a problem with a cross-purchase agreement.
KE Y E M PL O Y E E I N S U R A N C E
A “key employee” is an individual who possesses a unique ability essential to the
continued success of a business. This uniqueness may include the capital they control,
or the energy, technical knowledge, experience, management ability or other areas that
makes this person a valuable asset to the company. To determine whether a person is a
key employee, the question is whether the death of this individual could severely
handicap the company.
The answer to any such question, if positive, would indicate a problem that can be
solved, at least partially, by life insurance. Obviously some individuals are so “unique”
in their ability that they cannot be replaced, however in most situa tions, an individual
148
can be replaced provided there is sufficient time and expertise available. In any event,
an infusion of funds can, at the very least, alleviate the problem.
The amount of life insurance is essentially “informed guesswork.” If the services of the
key employee were to be lost suddenly, the financial loss to the company must be
estimated. The life insurance benefits should equal the present value of the projected
lost earnings, plus, there should be sufficient funds to pay the salary of the replacement.
But in actual practice, the company would generally have to pay more to the
replacement thant what they paid to the key employee. If an experienced and competent
individual were hired, they would be “starting at the bottom” and would therefore
demand a higher income.
Key man insurance can be furnished by nonqualified plans such as those discussed
below. In addition, there can be other plans adapted to meet the particular situation that
might arise upon the premature death of a key employee.
PERMANENT LIFE INSURANCE
On a typical key employee plan using permanent life insurance, the employer pays the
premiums on the policy. Dividends generated by the policy are used to pay the income
tax of the key employee (caused by the employer paying the premiums, as under federal
tax laws, employer-paid premiums are taxed as additional earned income for the
employee). Under many of the permanent policies, after the policy has been in force
for a few years, the dividends could exceed the taxable premium income to the
employee.
The advantages of permanent life insurance to the key employee include life insurance
coverage for life, increasing cash values, increasing dividends, selection of beneficiary
and ownership of the policy.
Key employee insurance may only be purchased by non-deductible dollars, however the
death proceeds are generally received income-tax-free by the corporate beneficiary
under IRC Section 101.
NOTE: Corporate beneficiaries may be subject to the Alternative minimum Tax, as
discussed earlier. For corporations, this brings insurance policy gains in excess of
premium and death benefits in excess of cash value, into the AMT as these gains are
added to a corporations book income. (See earlier note regarding possible repeal of the
AMT.)
TERM LIFE INSURANCE
When Term life insurance is used for key man insurance, the premiums that are paid by
the employer are considered federal taxable income to the employee. The employee
selects the beneficiary and owns the policy. Generally, thes e policies will not remain in
force after retirement as premiums continue to increase with age and become
prohibitive (unless the employee is in very bad health, in which case they may wish to
pay the extra premium under a separate arrangement with the emp loyer).
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SALARY CONTINUATION PLAN
As with the other key-man insurance plans, under the salary continuation plan the
employer purchases (usually) permanent life insurance on the life of the employee. The
employer is the beneficiary of the insurance policy, and owns the policy.
If the employee dies before receiving all promised supplemental pension benefits, the
employer pays the remaining supplemental pension benefits to the beneficiary of the
deceased employee. Funds for payments are provided from the li fe insurance proceeds.
Life insurance is used as an investment vehicle because employers promise employees
not only supplemental employee retirement benefits (private pensions), but also benefits
in the event of the employee’s premature death.
DEATH BENEFIT ONLY LIFE INSURANCE PLAN
The employer usually purchases permanent life insurance on the life of the employee, is
the beneficiary of the policy, and owns the policy. The premiums paid by the employer
are not considered federal taxable income to the em ployee. Upon the death of the
employee, the employer will use the life insurance proceeds to pay death benefits for
several years to the employee’s beneficiary. The employer receives the life insurance
proceeds tax free; however, the death payments to the employee’s beneficiary are
federal taxable income to that beneficiary. This plan can also be utilized to supplement
the employee’s pension plan at retirement.
SPLIT-DOLLAR LIFE INSURANCE
The split-dollar plans are not technically “key man” insurance, but can be used for that
purpose, as the employer still receives the death benefits in case of premature death of
the employee. This plan, and those that are described below, are actually non -qualified
executive benefits.
The “split-dollar” plan is a different approach as the premiums are “split” between the
employer and the employee. It is also called an Endorsement plan because the
employee’s rights are protected by an endorsement on the policy that provides that the
beneficiary designation of the employee which allows the beneficiary to receive the
excess cash value, cannot be changed without the insured employee’s consent.
Permanent life insurance is purchased on the employee, and the employer has an equity
interest in the cash value of the policy into which the employer paid premiums. The
employee has an equity interest in the cash value of the policy to the extent that the
cash value exceeds the premiums paid in by the employer.
Some insurers permit the ownership of the policy rights to be split, the
insured/employee being designated as the owner of the portion of the death benefit in
excess of the cash value, and the employer is designated as owner of all the other policy
rights and benefits.
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Under many permanent policies, the cash values will accumulate to a substantial sum,
whereupon the employer can withdraw from the cash value an amount equal to the
amount of premiums that the employer has paid into the policy.
At this point, the split-dollar plan terminates, and the employee has the sole p ossession
of the insurance policy. The cash values remaining should be sufficient so that no
further premium payments are required by the employee to keep the policy in force.
There are actually many ways to design a split-dollar contract. An employee may
notice that the initial contribution to the contract is substantial, but in later years, it
becomes zero. Therefore, they may ask the employer to average these charges over a
number of years to make it easier to start the plan. Also, an employer may do a
variation (a “no-split” split dollar plan) in which the beneficiary provisions are set up as
with the split-dollar plan, but the employee does not contribute.
The measure of taxability for split-dollar plans can be found in “PS-58” tax tables
which are IRS tables used in computing the cost of pure life insurance protection
taxable to the employee under qualified pension and profit sharing plans, split -dollar
plans, and tax-sheltered annuities (See table on page 148). The actual cost of standard
issue life insurance offered by the insurance company providing the coverage may also
be used.
A “Second-to-Die” or survivorship life policy can be used for split -dollar plans. It is
important that the plans terminate the split-dollar arrangement at the death of the first
party, otherwise it can cause tax problems to the survivor in the form of imputed
income to non-employee insureds.
Reverse Split-Dollar Plan
A variation of this plan, often called “Reverse Split-Dollar” plan is created by changing
who typically gets and pays for the account value of the policy. In effect, the
employee’s primary objective is not a substantial amount of life insurance, but rather a
substantial build-up of assets. Therefore, the corporation would pay the expenses and
the mortality cost, and the investment account would become the property of the
employee, i.e., the employer gets the death benefit and the employee gets the cash value
which has been growing on a tax-free basis.
The “reverse” split-dollar plan was not particularly attractive in the past, however with
the recent surge in the stock market and with the introduction of interest -sensitive
insurance products, particularly variable universal life, there is much more interest in
this approach.
This approach has definite tax advantages, and therefore any such arrangement should
be structured with legal and professional accounting advice, as tax laws have been
known to change frequently and sometimes drastically.
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CONSUMER APPLICATION
Ajax Corp. wants to purchase key man insurance on Bill, age 50, non-smoker, for
$200,000. Ajax agrees to use the reverse split-dollar approach. Using a variable
universal life insurance policy, a relatively conservative funding level would be about
$4,000 per year. Of this amount, Ajax would pay the PS-58 costs for Bill, which is
$9.22 per $1,000 for the year (age 50), or $1,844 (200x$9.22). Bill would then be
responsible for paying $2,156 per year.
When the policy is examined, it could easily show that the total expenses only amount
to $1,200 (for which Ajax has paid $1,844). The extra money ($644) goes into the
employees investment account.
The $644 is an extra “bonus” caused by using the PS-58 tables. (How long this tax
break will continue is anybody’s guess.) However, this reverse split-dollar arrangement
is a “good deal” for the company and for Bill, regardless of the “bonus.”
Collateral Assignment System
Under the Collateral Assignment plan, the insured employee applies for the policy and
is the owner of the policy, and therefore designates the beneficiary. The employee is
primarily liable for the premium payment also. This sounds like a typical individual
life insurance purchase, which it is up to this point.
The employer and the employee enter a separate agreement, wherein t he employer
agrees to loan (usually interest-free) the employee an amount equal to the annual
increase in the cash value. Therefore, the employee has an actual cost of the portion of
premium of each annual premium that exceeds the annual cash value increa se.
Because there is a loan involved, the policy is assigned by the employee to the
employer as collateral (hence the name) for the loan.
At the death of the employee, the employer receives the amount of the loan from the
death proceeds (not as a beneficiary, but as a collateral assignee).
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P.S. No. 58 Rates
The following rates are used in computing the “cost” of pure life insurance protection that is taxable to
the employee under qualified pension and profit sharing plans, split-dollar plans, and tax-sheltered
annuities. Rev. Rul. 55-747. 1955-2 CB 228: Rev. Rul. 66-110. 1966-1 CB 12
One Year Term Premium for $1,000 of Life Insurance Protection
Age Premium
15
1.27
16
1.38
17
1.48
18
1.52
19
1.56
20
1.61
21
1.67
22
1.73
23
1.79
24
1.86
25
1.93
26
2.02
27
2.11
28
2.20
29
2.31
30
2.43
31
2.57
32
2.70
33
2.86
34
3.02
35
3.21
36
3.41
(Premiums are dollar amounts)
Age Premium
37
3.63
38
3.87
39
4.14
40
4.42
41
4.73
42
5.07
43
5.44
44
5.85
45
6.30
46
6.78
47
7.32
48
7.89
49
8.53
50
9.22
51
9.97
52
10.79
53
11.69
54
12.67
55
13.74
56
14.91
57
16.18
58
17.56
Age Premium
59
19.08
60
20.73
61
22.53
62
24.50
63
26.63
64
28.98
65
31.51
66
34.28
67
37.31
68
40.59
69
44.17
70
48.06
71
52.29
72
56.89
73
61.89
74
67.33
75
73.23
76
79.63
77
86.57
78
94.09
79
102.23
80
111.04
81
120.57
The rate at insurer’s attained age is applied to the excess of the amount payable at death
over the cash value of the policy at the end of the year.
Choosing the Best Method of Split-Dollar Plan
In determining the best split-dollar system to be used, the first consideration should be
whether the employer wants the cash value to be available for business use during the
time the split-dollar plan is in force. If this is the case, the endorsement system or split
ownership system is best, as under the collateral assignment system, the employer
generally cannot receive any of the cash value.
Under the endorsement system, the employer can borrow from the policy at any time
and for any reason (the employer is the policyowner). If the employee is not a
stockholder or an officer, this method might be better as the policy and the protection it
affords would be lost in the event of employment termination.
153
If the policy is going to be used to fund a retirement arrangement (nonqualified) the
endorsement method would be best because at the employee’s retirement, the employer
can take out a policy loan, receive the cash value under a settlement option, or continue
to pay the premium until the employee’s death.
If the collateral method is used, since the employee owns the policy, it will have to be
transferred to the corporation if it is to be used to fund a (nonqualified) retirement plan.
This could subject part of the death proceeds to income taxation if the insured employee
was not an officer or shareholder.
If an in-force policy is to be used, and owned by the employee, it is easier to use the
collateral assignment system. Conversely, if the polic y is owned by the employer, it is
easier to use the endorsement method.
If a major purpose is to allow the employee to accumulate savings under the policy,
then the collateral assignment method is best.
MISCELLANEOUS USES OF SPLIT-DOLLAR PLANS
Sole Proprietor
In certain, and rare, situations, the sole proprietor may not have anyone to whom they
wish to leave their business. If such is the case, then the business owner may wish to
sell to an employee that would like to have the business if the owner shoul d die.
Usually the employee does not have the funds to purchase the business, so the employee
and the employer could enter into a split-dollar situation, but in this case, the insurance
is on the life of the employer instead of the employee.
Cross-Purchase Buy-and-Sell Agreement
The major disadvantage on this type of arrangement is that the shareholders are
personally responsible for the payment of the premiums on the insurance policy used to
fund the plan. The corporation can help fund the plan by using the split-dollar
arrangement, and the collateral assignment method is usually used. In effect, each
shareholder applies for and owns a policy on the life of the other shareholders. Each
shareholder then collaterally assigns the policy the shareholder ow ns on the other
shareholder’s life, to the corporation as security for the corporation’s premium
payments.
However, if a split-dollar plan is used to fund this cross-purchase plan and it uses the
collateral endorsement system, it could be considered as a “transfer for value” to the
other shareholders of the insured. One approach to eliminate this problem, is to set up
the ownership and beneficiary arrangement when the policy is first issued, and thus, the
transfer is avoided.
Also, if one of the parties to the cross-purchase agreement is a majority shareholder,
using a split-dollar plan to fund the agreement could possibly create estate tax
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difficulties. Because of tax laws regarding incidents of ownership (without going into
lengthy details) the value of the stock in the corporation and the insurance proceeds
received by the co-shareholder and used to purchase stock, will both be included in
his/her gross estate.
Family Split-Dollar Plan
A split-dollar plan can also be used for family matters such as providing insurance
protection for a married child, but they do not want to reduce the estate so that all of the
children (or other heirs) will have their full share. The parents pay the premiums on the
policy, typically with the spouse of their child as beneficiary, with the agreement that at
the death of the insured child, the parents will receive the total amount of premiums
they have paid. They have provided protection at a minimum outlay, and there are no
tax implications, even gift taxation would not come into play as the $10,000 annual
exclusion would apply.
CONSUMER APPLICATION
The Bradleys have five children, the oldest is Ben, a schoolteacher, married with two
children. The Bradley’s are concerned that if something happens to Ben, they would
have to take funds from the estate that they feel also belongs to the other four children,
in order to help Ben’s family.
The parents purchase a life insurance policy on Ben’s life, with Ben’s wife named as
beneficiary and children as contingent beneficiaries. Since Ben is still relatively young,
they are able to purchase a policy with enough death benefit so that Ben’s family will
be well cared for. They have an agreement with Ben so that in case of Ben’s death, the
total amount of premium that they have paid will be returned to the parents from Ben’s
estate. The agreement is also signed by Ben’s wife.
The Bradley’s have created a trust for their children, and if his parents die before Ben,
the trust will continue making premium payments on the policy, with the amount of the
premiums subtracted from Ben’s share of his parent’s estate.
EXECUTIVE BONUS PLAN
The executive bonus plan is quite simple. The employer purchases life insurance
policies on selected employees and since the employer is paying the premium, it is free
to discriminate among employees benefited by this plan.
Since it is nonqualified, the premiums are considered as taxable income to the employee
and are tax deductible to the employer (unless the IRS finds that the payments are
“unreasonable”).
The employee owns the policy, names the beneficiary and has all other policy rights.
However, the death benefits will appear in the employee’s gross estate if the employer
retains any ownership interest, or the proceeds are payable to or f or the benefits of the
estate.
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STUDY QUESTIONS
Chapter 8
1.
2.
3.
4.
5.
6.
An important characteristic of a closely held business is
A.
numerous stockholders.
B.
it is usually not marketable.
C.
when an owner dies the business is liquidated and it is not considered important.
When a sole proprietor dies
A.
the personal representative of the estate can run the business.
B.
it does not signifially effect the business.
C.
the debts of the business become the debts of the estate.
The type of closely held firm that continues when an owner dies is a
A.
sole proprietorship.
B.
closely-held corporation.
C.
general partnerships.
An agreement whereby the business is obligated to buy out the ownership of a deceased
partner is
A.
a cross-purchase buy-sell agreement.
B.
redemption plan.
C.
entity buy-sell agreement.
If life insurance is used to fund a partnership buy-sell agreement the
A.
premiums paid are not deductible.
B.
proceeds are usually taxable.
C.
proceeds are included in the insured’s estate.
A closely-held corporation is usually
A.
owned by a professional partnership.
B.
owned by a small number of people.
C.
openly traded on a national stock exchange.
156
7.
8.
9.
10.
A “key employee” is
A.
an individual that posses a unique ability essential to the success of a business.
B.
usually a stockholder.
C.
always an officer in the company.
With “key employee” insurance
A.
the employee pays the premium.
B.
the premiums are deductible as a business expense.
C.
there are advantages to use permanent life insurance.
With “key employee” insurance the premium is paid by the _______________ and the
_____________ is the beneficiary.
A.
business/business.
B.
employee/business.
C.
employee/employee.
With a split-dollar life insurance policy
A.
the premiums are split between the employer and the employee.
B.
term life insurance is purchased on the life of the employee.
C.
the employee is the insured but has no interest in the policy.
Answers to Chapter Eight Study Questions
1B 2C 3B 4C 5A 6B 7A 8C
9A
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10A
C H A P T E R N I N E - U N D E R WR I T I N G
The term “underwriting” has a double connotation in life insurance. Originally, the
word “underwriting” came from the practice of wealthy individuals and firms assuming
certain risks, usually maritime (marine) risks. When accepting these risks, the practice
was for these individuals or firms to sign under the terms of the contract, hence the
name “underwriter.”
In life insurance, individuals who market life insurance are called underwriters, or
“field underwriters.” Those individuals who have taken a series of examinations from
the American College of Life Underwriters, and have prescribed experience in life
insurance, are awarded the designation of “Chartered Life Underwriters.”
This chapter discusses the process by which an insurance company determines the risk
of an application submitted by an individual and determines if the risk is acceptable to
the insurer, and if so, on what basis. The individuals who do the risk selection and
classification, are called “underwriters,” or “home office underwriters.” They have
their own professional designation, “Fellow, Home Office Underwriters Association”
which is awarded after a series of examinations and completion of experience
requirements. Their primary responsibility is to assess the potential of loss of each
applicant from information that they gather from various sources, and then determine
what classification or “loss potential” is the closest of that of the applicant.
The process of underwriting consists of two separate functions: Selection and
Classification.
Selection is the process of determining whether the applicant meets the insurability
criteria and standards of the insurance company, and to measure the risk s involved. The
next step is Classification, which is the process wherein an underwriter assigns the
individual to a “class” of insureds, or group of insureds, who have approximately the
same loss probabilities as that of the insured.
Underwriters deal more with probabilities than with certainties – although in life
insurance there is a certainty of a loss if the policy stays in force long enough. The
question of when the insured will die is not certain, but by the insured being assigned to
a group of similar insureds with similar attributes and health history, whose life
expectancies should approximate that of the insured, and to do so in a manner that is
equitable to the insured and profitable for the company, the underwriter has performed
his duties.
Group insurance is underwritten differently than individual, as described later, as each
group is expected to contribute a premium that is sufficient to cover its loss potential.
However, individual insurance is different, as each individual should pay an amount
which is sufficient to cover the expected value of his/her losses. If some of the insureds
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pay premiums that are insufficient to cover adequately the expected losses (and
expenses of the insurer) the other insureds must make up the difference, in effect
“subsidizing” the other insureds.
Each insured in each “pool” would expect to receive a loss -payment in the form of a
subsidy, from other members of a pool. This would mean that those who least expects
to suffer a loss would drop from the pool, leaving only those that have greater
expectations of receiving a loss payment from the “pool.” This creates adverse
selection, and the underwriter’s function is to reduce adverse selection as much as
possible.
Obviously, those persons applying for life insurance vary widely in various areas.
Many are overweight (a few underweight), some are in ill health or at death’s door,
others are in excellent health and the majority is in good health, and many do not have
the slightest impairment. Those who are in good health and meet the standards for
insurance of the company are considered as “standard” risks. Those who do not meet
the qualifications are called “substandard” risks.
If complete information on an individual was available, and then underwriting would be
straight-forward and there really would be no need for home office underwriters.
Facetiously, if an applicant were able to furnish only accurate facts to the insurance
company, the company could issue the policy and would be guaranteed of a profit. All
they need to know are (1) the date of birth, and (2) the date of death.
ADVERSE SELECTION
Adverse selection starts when an applicant who is uninsurable or a greater than average
risk, seeks to obtain a policy from a company at a standard premium ra te. Life
insurance companies carefully screen applicants for this reason, since their premiums
are based on policyowners in average good health and in non -hazardous occupations.
While this chapter discusses the application process, adverse selection also exists when
existing insureds believe their premiums are too high in relation to their specific loss
potential, and they can discontinue their insurance without penalty or without a
significant penalty. In other words, the “best” risks leave the group an d cancel their
insurance, leaving behind those who believe that their premiums are accurate or
inadequate (those of a higher risk), with the results that the premiums for the remaining
group then become under-priced, but if the premiums are raised to meet this higher
anticipated loss ratio, then the cycle repeats, where eventually the only ones who
remain in the pool are those who are so large a risk that they must stay in the pool.
In life insurance, if the applicants know that an insurance company will o ffer them
insurance without performing any underwriting, those who are in poor health or those
who expect to have higher mortality than the average; will apply for the coverage in
anticipation of a more favorable rate.
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Conversely, if they know that the insurance company will investigate their insurability
status, those who are in poor health or would be classified as substandard for other
reasons, would either not apply or would submit truthful applications as they would be
aware that the insurer will check on the accuracy of the answers.
UNDERWRITING FACTORS
Factors primarily used in the home office underwriting process and included on the
application include age; sex; physical condition and personal health history; family
health history; financial condition; use of alcohol or drugs or tobacco; occupation;
avocation and military status. At times, aviation and residence location are also
considered.
AGE
Since expected future mortality is correlated with age, the older a person, the higher the
mortality risks. While many people are “young for their age”, or vice -versa, there is no
way to measure the biological age of a person, so the underwriters (and actuaries) have
to use chronological age only.
Age is not a key factor in whether a risk is acceptable, except in the very early years
and in the later years, and some insurers will not insure a new born baby or a person of
advanced years (such as age 75). For the older ages, the premium might be so high that
it is not attractive to persons of that advanced age (or if it were available, adverse
selection might rear its ugly head again). With the very young, the mortality rate is
also very high for a short while. In any event, the insurance company would probably
not insure enough people in those categories to have a sufficient spread of risk.
Proof of age is not required at time of application as few people misstate their age and
verification of age is relatively easy, if necessary. Besides, the “misstatement of age”
provision in the policy takes care of adjusting the premiums or risk accordingly.
SEX
Sex, like age, by itself, is rarely used for selection of risk, but is a classification as
mortality tables show that the mortality of males and females are different – the
mortality of females are better (lower) than that of males. Interestingly, this was not
always true as insurance companies used to charge the same premiums during child bearing years, as they felt that the increase in mortality because of the hazards of
childbirth offset any other mortality advantage of females. Today the childbirth-hazard
has diminished to where it generally is no longer a factor.
Since females should be charged lower premiums for life insurance based on lower
mortality, it also then follows that females should be charg ed higher premiums for
annuities. While this is true, the question arises whether it is socially acceptable for
males and females to be charged different rates, which has led to “unisex” rates, i.e.,
there is one premium for both male and female.
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PHYSICAL CONDITION
In underwriting, the most important factor is that of the physical condition of the
insured. There are several primary factors of the health of the applicant that are
carefully scrutinized. Health information about the applicant comes from sev eral
sources, as discussed later, but primarily from the statements of the insured on the
application and from physician’s statements regarding past health history admitted by
the applicant. (Sources of underwriting information are discussed in detail lat er)
BUILD
Build includes height, weight and the distribution of the weight. Everyone is aware that
being significantly overweight can cause an early demise, but an underwriter also has to
be aware of how even moderate overweight can affect other physical conditions, such as
diabetes or a heart condition.
ABNORMALITIES
The mortality experience of an applicant will depend upon certain physical
abnormalities as they affect the important parts of the body, such as the nervous system,
digestive, cardiovascular, respiratory or genitourinary systems and other glands. It is
outside the scope of this text to go into detail as to how various problems in this area
affect mortality, but some of these are obvious.
Problems with the circulatory systems, such as high blood pressure, a heart murmur, or
fibrillation’s of the heart (irregular or erratic heart beat) are of considerable interest as
they can lead to higher than normal mortality. A urine specimen can discover internal
problems, particularly with the blood and/or kidneys. Conversely, low blood
cholesterol; normal or lower-than-normal blood pressure and non-use of tobacco are
“plusses.”
There is always concern about AIDS because it spreads so easily and it has a fatal
effect. When AIDS first was diagnosed, there was a lot of concern about privacy of
medical records and unfair discrimination. Today most of the issues about privacy,
confidentiality and discrimination have been resolved, and insurers now treat AIDS like
any other disease, but the right to test individuals for AIDS is still controversial and in
some jurisdictions, testing is prohibited.
PERSONAL HEALTH HISTORY
Insurance companies inquire into the background of their applicants in those areas that
would have an impact on future mortality. This includes the individual’s health records
and other non-health area, such as driving records and possible over insurance.
As indicated earlier, most of the health history comes from the application and from
attending physicians and/or hospitals. The applicant for life or health insurance signs a
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form (usually at the bottom of the application) which gives any doctors or hospitals
permission to furnish medical records to the insurer.
In many cases, if an individual has not had a physical examination for a significant
number of years, the insurance company can ask the applicant to submit to a physical
examination, usually, but not always, at the expense of the insurance company. Para medical examinations, which are performed in the applicant’s home o r business office,
are quite common. If the underwriter requires a more detailed examination, such as a
stress test, these are usually performed at the expense of the applicant.
If there is or is suspected of being, a cardiovascular problem, and an electrocardiogram
(EKG) may be requested and copies of past EKG’s may be requested also. Insurers
either have a medical director on staff, or the application and medical records may be
sent to a reinsurer for their interpretation and evaluation. (Reinsurers have expert
medical underwriting staffs.)
Over insurance discovered through insurance history is important. If an applicant has
more insurance than normal, and perhaps more than is financially justified, the
underwriter has to ask himself, “What does he know that I don’t?” Records from other
insurance companies can be requested, however in most jurisdictions an insurer may not
render an underwriting decision based upon only the records of another insurer.
FAMILY HISTORY
The magic word here is “heredity.” Many diseases can be transmitted from generation
to generation and family health history is heavily influenced by inherited genetics. If
the parents of an applicant lived to a “ripe old age,” then genetically speaking, there is a
good possibility that the applicant will also. Conversely, if both parents died of heart
conditions at an early age, then the underwriter will pay particular attention to any
coronary problems, overweight, cholesterol, etc.
TOBACCO USE
Insurance companies are now well aware that smoking and other tobacco use causes
mortality experience to worsen, even in the absence of other physical factors. In
addition, smoking can aggravate many other health problems.
Most insurance companies now have smoker and non-smoker rates. Even though the
smoker rates will be considerably higher, in many cases they are not adequate ,
particularly if the person is a heavy smoker. Actually, female smokers have higher
mortality than the nonsmoking male. Where there is no differentiation, most in surers
consider the “standard” grouping as 75 percent nonsmokers who have about 85% of
expected mortality, with the remaining 25% having about 150% of expected mortality.
This differs by age and as an example, those ages 40 -49 that are tobacco users have
about twice the mortality rate of the nonsmokers.
It should be understood that the nonsmokers are not a “ super standard” class, and
because of the continuing decline in smoking in the U.S., the nonsmokers will soon be
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(and in some cases, already are) the “standard” classification. The smokers will be (or
are) considered “substandard” and will pay additional (substandard) premiums.
FINANCIAL CONDITION
The reputation of the applicant in meeting financial obligations can indicate the moral
risk involved with the applicant. Financial condition, which includes personal net
worth, size of income, sources of income, and permanency of the income, are very
important underwriting factors.
The relationship between the income and financial worth of the individual a nd his life
insurance coverage, in force and applied for, can indicate good or bad financial and
estate planning. However, if the amounts are quite large, then the underwriter must
start questioning as to the reasons for the difference in amount. Again, what does the
applicant know that the underwriter does not know?
CONSUMER APPLICATION
In the early 1970’s, a cattle rancher from Oklahoma applied for life insurance in the
amount of approximately $15 million, at that time considered as a huge policy. W hile
the applicant actually wanted more insurance, this amount was all that was available
anywhere, and even reinsurers worldwide kept their maximum amount (retention). The
inspection company did not fully verify the finances of the applicant, and they ac cepted
the word of the applicant as to his net worth without precise verification, as he was very
well known and influential in Oklahoma, he had a huge ranch, and his wife was wealthy
in her own right.
13 months later, the insured was found in the basement of his home, stabbed and
bludgeoned to death. Nearby was his injured “bodyguard,” an ex -convict who claimed
that the “assailant” had stabbed him.
Claims investigations discovered that the insured was on the verge of bankruptcy and it
was suspected, but not proven, that he owed a lot of money to the Mafia. It was also
discovered that the partner of the General Agent who had written the policy, was
discovered to be a former “Mafia hit man” and was found murdered in a rural area in
Canada, not far from the body of another known hit man.
The murder was never solved. The insurers settled for a little over 50% of the face
amount of the policy. (As an aside, apropos to nothing, the widow married the
bodyguard, then divorced him and married her attorney.)
If the underwriters (and each reinsurer underwrote the case in addition to the company
underwriter – there could have been as many as 25 or more underwriters review the
application and records) had been aware of the financial difficulties, it is extremely
doubtful that this policy would have been issued, at least for that amount. At time of
claim, it was reported to be the largest claim in U.S. life insurance history.
(Incidentally, there is a movie and a book about this actual case.)
ALCOHOL AND DRUGS
If the applicant is known to be an excessive user of alcohol, they can be either given a
substandard rating or declined. Participation in a support program or alcohol treatment
program can cause the application to be accepted or declined for a specific number of
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years without use of alcohol. The use of alcohol will severely affect the health of the
applicant in any event, and such tests as liver function tests, may be required.
For other drugs, if there is use of “hard” or illegal drugs, then the applicant i s declined.
If the drugs have been prescribed by a physician, then the underwriting concern is the
overuse of the drugs, and the reason for the drug treatment. A person who has used
occasional or recreational use of drugs, and has not used them for an ex tended period of
time since the last usage, and can show reliability and responsibility, etc., is probably
insurable, depending upon the time frame.
OCCUPATION
Occupational hazards used to be much more significant than they are today, thanks to
safety measures taken by various industries. The hazards today are still present in three
specific areas.
The occupation may create an occupational hazards, such as working where drugs
and/or alcohol are sold &/or used. The occupation may have an effect upon the health
and well being of the individual because of environmental or other factors, such as
inhaling chemicals or whose working conditions may be of such a nature that diseases
are rampant or frequent, such as close, dusty and cramped quarters. There is al so a risk
from accidents, and people who are susceptible to accidents are carefully scrutinized,
such as racecar drivers, crop-dusters, etc. Years ago, private pilots could not get life
insurance or the rates were prohibitive. Now, insurance is available and the rates
depend upon the experience of the pilot.
A person, who is rated because of occupation, may change occupations to one that is
safer. As a general rule, the insured would have to remain at the new safer job for a
certain period of time, and then apply for a rate reduction. In initial underwriting, the
practice is usually to ignore a hazardous occupation if the applicant has been away from
that occupation for a year or more.
AVOCATIONS
With a higher standard of living than previous generations, many of the newly rich (and
those not so rich) spend more time and money than ever before in the pursuit of
exhilaration. This has shown an increase in such sports as scuba diving, rock climbing,
parachute jumping (sky diving), hang gliding and competitive racing. These activities
can often be considered hazardous and should be considered in the underwriting
process. Many times a flat extra premium will be added to cover the added risk and in
some situations, the applicant will be declined.
MILITARY SERVICE
When the country is at peace, insurance is usually offered to military personnel.
However, when the country is at war, then the problem of adverse selection arises,
particularly when a serviceman has just been issued orders to join a unit in comb at. In
these cases, either the application is declined, a limit on the amount of insurance is
offered, or a war exclusion clause which limits the payment to return of premiums if the
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insured is killed in a military action, but pays the full face amount if death is caused by
other than military action.
The war exclusion clause was used in WWII and in Korea, but not during the Vietnam
War. An interesting feature of this clause is that when war or hostilities cease, these
war clauses are routinely cancelled and they cannot be brought up again.
It is too early to tell what the response to the present (2001) war against the terrorists
will be in respect to the war clause, but the thinking at this time is that if the “war” is
contained as anticipated, public opinion would be so solidly against any such restriction
that the insurance companies would probably not even consider such a clause.
There are two other areas of concern to an underwriter, but they do not arise often.
Aviation risks apply to private pilots, but can also apply to commercial pilots and
military pilots. Where there is a definite aviation hazard, the applicant will be asked to
complete an aviation questionnaire and based upon these answers – which are
concerned primarily with experience, t ype of aircraft and frequency of flying as a pilot
– an additional premium may be charged. Flights by fare -paying passengers are not
considered as a hazard and there are no extra premiums charged. Most scheduled
airline pilots and experienced private pilots are issued insurance with no aviation
restrictions.
The other area is that of residence. If a resident of the U.S. is going to take up
residence in a foreign country, depending upon the living standards of the country and
the political atmosphere, there may be an extra premium charged, and in some cases,
the application may be declined. For a foreign resident moving to the U.S., the big
problem is developing underwriting information. And then if a claim should occur,
obtaining claims information is a problem. The currency problem in other countries can
come into play also.
U N D E R W R I T I N G I N FO R M A T I O N
As mentioned earlier, sources of information used in underwriting comes from a variety
of sources, but primarily from the following:
 applications;
 physical examinations;
 laboratory testing;
 agent’s statements;
 attending physician reports (APS);
 inspection companies;
 databases sponsored by the insurance industry
APPLICATIONS
There cannot be enough stress placed on the importance of the application.
Nothing can compare to a completed and accurate application.
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Part I of the application contains questions about personal information, such as name,
addresses, business addresses, occupations, sex, date of birth, relation to beneficiary,
etc. It also asks about type of insurance applied for and in force, driving record, past
declination or modification of insurance in force or applied for, aviation, avocations,
foreign travel, etc.
Part II is the medical history of the applicant, with details and names of doctors and
hospitals in attendance, both present and within the past 5 years (or more), questions
regarding the physical well-being of the applicant, use of alcohol or drugs, and family
history.
A copy of the application becomes part of the insurance pol icy.
PHYSICAL EXAMINATION
As discussed earlier, if a physical examination is necessary, the doctor or paramedic
conducting the physical will complete a form prescribed by the insurance company.
Copies of X-Rays, EKG’s, EEG’s and other test results may be required.
These examinations are very important and many medical conditions can be discovered
through these exams, but they are not fool-proof as many applicants attempt to conceal
health problems, and may come prepared for the physical by dieting and exercising
prior to the exam. Paramedical exams are usually used for the smaller amount policies,
but at a predetermined threshold, a “full” examination by a physician may be needed.
LABORATORY TESTS
Laboratory testing became more common because of the exposure to AIDS and illegal
drug use. With the public awareness of other health risks, such as cholesterol readings,
laboratory tests are used more and more and have been found to be cost -justified.
Tests usually consist of blood and urine specimens, and urine testing is used for
controlled substances, medications, and nicotine.
New genetic research finds that genetic testing can be invaluable for insurers. Presently
insurance companies consider genetic testing as any other testing and genetic tests use d
by medical professionals for treatment and for preventative medicine are used as any
other test. Insurance companies do not order genetic testing as part of the underwriting
procedure.
ATTENDING PHYSICIANS’ STATEMENTS
If the application completed by the insured contains medical history, it is common
practice (mandatory with some companies) to obtain copies of the medical records.
These are called “Attending Physician’s Statements”, better known as “APSs.” In some
cases, the agent or agency will request an APS at time of application. In some
situations and with some companies, the company will pay for the APS (usually if the
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charge is within reason as some physicians have discovered that this is a good source of
added income).
The medical records of an individual is legally confidential between the physician and
the patient, therefore the application will contain, either as a “tear -off” part of the
application, or on a separate form, an authorization for a copy of the insured’s medical
records to be submitted by the physician or medical facility, to the insurer. The APS is
generally considered as the most important underwriting source, but they can be subject
to delay (the doctor’s offices are notorious for not being in a hurry to copy and mail the
records) and on occasion, physicians have been known to refuse to submit records. The
medical records of the patient belong to the patient, and occasionally an agent or the
underwriter must request of the applicant that they obtain their own medical records.
INSPECTION COMPANIES
Underwriters order inspection reports from inspection companies which interview the
insured (or in some cases, do not interview the insured or a member of his family,
neighbors, employer and others, depending upon the request by th e insurer. Inspection
reports are now referred to as “consumer” reports and the inspection companies are
called “consumer reporting agencies.” Old-timers still frequently refer to them as
“Retail Credit” reports, after the name of the largest inspection company until it
changed its name. These reports are ordered routinely if the amount of insurance
applied for exceeds a certain amount (such as $100,000), &/or over a certain age.
Consumer reporting agencies are strictly regulated by the U.S. Fair Cred it Reporting
Act, which defines a consumer report as “a written, oral or other communication of any
information by a consumer reporting agency that has a bearing on the consumer’s
creditworthiness, credit standing, credit capacity, character, general reput ation, personal
characteristics, or mode of living, and which is used or expected to be used in whole or
in part to establish eligibility for credit, personal insurance, employment or certain
other purposes.” (Note that these reports are to be used for personal insurance.)
An “investigative consumer report” is a consumer report containing information on the
consumer’s character, general reputation, personal characteristics or mode of living, and
this information is obtained by personal interviews with t he consumer’s neighbors,
friends or associates.
When the amount applied for triggers an inspection report, the report may be ordered
from the home office of the insurer, or in some cases, by a field office. The completed
report is always submitted to the underwriting department of the insurance company. In
most states, the applicant must be notified in writing that they may be investigated.
The type of report will usually depend upon the size of the insurance amount applied
for. Insurers may require a short form that verifies the address, occupation and
employment of the applicant, or an intermediate form that requires more information.
For very large amounts, particularly if it is for business purposes, a very detailed report
is requested and may require interviewing the applicant’s bank, accountants, and other
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business affiliations and is usually billed on an hourly basis. The insurer pays for
inspection reports.
Insurers are becoming more comfortable with personal interviews and have discovered
that underwriting information that would not otherwise be known can be obtained by a
personal interview in the hands of a professional. Some insurers of other lines, such as
Long Term Care, use personal interviews frequently.
DATABASES – MEDICAL INFORMATION BUREAU (MIB)
The Medical Information Bureau, “MIB,” is one of the most misunderstood
organizations in the insurance industry. It is a membership organization with virtually
all insurance companies as members, and even those companies who are not memb ers
(usually very small or new) often receive the benefits of the MIB through reinsurance
underwriting on difficult or large cases. The MIB is a “repository” of confidential
information, most of which is of a medical nature, on people who have applied for life
or health insurance to the member companies. It is highly computerized and was
formed to protect insurance companies against fraud by insurance applicants.
Information is coded and members are required to report certain medical impairments,
obtained from a medical source or from the applicant directly. Contrary to popular
belief, the underwriting decision of the member companies is not shown on MIB data
and they do not state the type of size of the insurance applied for. Information other
than medical impairments is reported also, such as driving records, aviation, hazardous
sports activities and criminal activities or association.
 A member of the MIB may not make an unfavorable underwriting decision based
solely or in part, upon the information contained in the MIB.
In most states, the applicant must be informed in writing that the insurance company
may report information to the MIB, and how the applicant can obtain a copy of the MIB
report and dispute the report. Authorization to the MIB to release information on the
applicant is usually on the same form as the release of medical information
authorization.
CONSUMER APPLICATION
Bruce, who lived in Seattle, applied for life insurance in 1998 with Ajax Life. He
admitted on the application that he had recently been diagnosed with early stage
multiple sclerosis. He was declined by Ajax and the information on his illness was
coded and submitted to the MIB. Shortly thereafter, Bruce moved to Florida.
Being in the early stages of multiple sclerosis (MS), Bruce was aware that he was
subject to sudden seizures that could affect various body movements or functions, but
since he had not had any serious recent seizures, he never reported it to his regular
physician in Florida, but found a specialist in treating the disease which monitored
Bruce’s attacks. (Continued on next page)
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In early 2001, Bruce applied for life insurance with Acme Life. On his application he
never mentioned his MS or his treatment by the specialist.
The underwriter at Acme received an MIB report, filed by Ajax, showing that Bruce had
MS. The Acme underwriter contacted Ajax who sent the details that they had in the ir
files. Bruce was then contact by the Acme underwriter, but he denied any such illness
and denied ever having had a diagnosis or treatment of MS.
Acme may not make an underwriting decision based upon MIB information, so they
must obtain verifying information. Acme would require Bruce to submit to a medical
examination and test that would probably show that he had MS, and they would decline
the application. If they were not able to verify the MS diagnosis, for whatever reason,
they could not decline or rate Bruce’s policy based on the MIB report.
CLASSIFICATION PROCESS
It was mentioned earlier that life insurance underwriting consists of two phases,
selection and classification. Up to this point, the discussion has focused on the
selection process. At the next stage, the underwriter must determine whether the
applicant is insurable, and if so, on what basis. If the applicant does not meet the
underwriting criteria of the company, then the application is declined and the process
ends.
The only other choices are whether the applicant is to be accepted at standard rates, at
substandard rates (either temporary or permanent) or whether the application will be
postponed for a period of time (in those cases where the effect of a medical condition
can be better determined at a later date).
CONSUMER APPLICATION
Conrad is scheduled to have prostate surgery, non-cancerous, by an eminent urologist,
in 3 weeks. He had been talking to his brother-in-law who is an insurance agent, about
taking out a new life insurance policy to help pay off a mortgage on his new and
expensive house, in case he should die. He resumes the discussion, and makes an
application for insurance.
Conrad is in excellent health, in good financial condition, and meets the requirements
of a standard policy from the insurer. However, the underwriting decision would be to
postpone the application until a certain period of time after the surgery has been
successfully completed, at which time the application will be reviewed again and if
there are no changes, the policy can be issued.
In the early years of life insurance, decisions regarding medical difficulties primarily
were reviewed by the underwriter, an independent doctor or the company’s medical
director (who was a doctor), the actuary, and anyone else that may have some expertise
in the area. Basically, the application was either issued or declined, with little other
classification. This “judgement” method of underwriting obviously left a lot to be
desired, so the numerical rating system was devised.
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THE RATING SYSTEM
The numerical rating system (or alphabetical system described later) starts with the
“standard” rating of 100, i.e., a “standard” risk has a rating of 100. From this, any
factor that has an effect on the mortality of the applicant is judged by debits or credits,
generally in 25 “points” increments. The ratings range usually from 75 or less to a high
of 500 or more, with 125 or less considered as standard. Any application with 500 of
more rating is usually declined, or at least considered as experimental underwriting.
Many companies consider ratings of 75-85 as “preferred,” 100 to 125 as standard, 150
to 500 as substandard.
Generally, underwriting decisions are in multiples of two, expressed as “Tables.” For
instance, if the medical condition falls within 50 additional points, then the application
would be classified as “Table 2.” If the conditions were more severe, then it would
normally be rated at Table 4. There usually is no Table 3,5,7, etc. in normal
underwriting practice with most companies, but they could be used if there were a
combination of “positive factors”, such as an applicant who is slightly underweight but
is active and other than a particular health problem, is in above -average condition. The
rating might be a Table 4 for the health problem, but reduced by a Table for the good
health, and the policy could be issued at a Table 3 – depending upon whether the
company has Table 3 rates. Normally, however, the inclination would be to issue at
Table 2 for competitive purposes with typical ordinary life insurance applications.
Some underwriters interpolate the numerical ratings into alphabetical ratings. For
instance, a Table 4 would be Table D (the 4 th letter).
Underwriters use Underwriting manuals which are either based upon their own
experience on their own business (usually only the very large companies) or manuals
provided by the reinsurance companies. Most illnesses, impairments and diseases are
listed, with descriptions and with suggested ratings.
If an individual has more than one illness/disease/impairment or ratable condition, as
happens very frequently, often the two rating are not added together, but an additional
rating is added when there are multiple conditions. An overweight person who has a
little coronary problem would be rated at more than the combination of the two, or
could even be declined because of the two, but would have been accepted if it were only
overweight or only coronary.
CONSUMER APPLICATION
Herbert applied for a life insurance policy. On the application he indicates that he is 37
years old, 5’10” tall, weight 215 pounds and he has had a “little high blood pressure”
but is not under medication or treatment. He is a non-smoker, non-drinker and he is
active physically. His parents both are alive, in there 60’s and his grandparents both
lived into there 90’s.
A paramedical exam showed a blood pressure of 155/90.
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(Continued)
Herbert would be rated for overweight by build tables used by the company.
Build-overweight: 25 points added; Blood pressure: 75 points added; and Family
history: 10 points credited. In addition, the combined weight and blood pressure ratings
would be increased by an additional rating as the combination places Herbert in a
higher risk category.
Herbert’s total classification would be over 200 points (remember, everyone starts with
the “standard” of 100 points) and definitely substandard.
Practically speaking, his history of weight and blood pressure would determine whether
the underwriter would consider a lower rating for competitive reasons. If the total
rating is Table 6 or lower, and there are no other health factors, another company may
offer a Table 4, depending upon the plan, etc.
RATING IMPAIRED RISKS
There is a large (huge, actually) market for impaired risks, i.e., substandard risks
applying for life insurance. The life insurance industry continues to change, and as new
medical advances appear, the industry takes them into consideration. Many of the
standard or slightly substandard policies available today could not have been issued
only a few years ago.
Thanks largely to computers, insurance companies are able to compile statistics that
enable them to better understand the effect of impairment on the expected mortality of a
particular class of business. Many advances in impaired risk underwriting are a result
of the influence of reinsurers. Reinsurers, and in particular, foreign (European mostly)
reinsurers have been pioneers in underwriting impaired risks. Reinsurers have
competed vigorously for impaired risk business, many of them accepting substandard
risks with the understanding that they will also participate in standard business written
by the insurer. Reinsurers have conducted seminars in underwriting, participated in
industry underwriting and actuarial conventions and have created and furnished
underwriting manuals for underwriters (most life insurance underwriters have at least
one, and frequently several, reinsurance underwriting manuals) at no cost to the
underwriters.
Reinsurers are generally able to accept business that smaller companies cannot accept,
because of the large block of business that they have in force. Reinsurers “reinsure”
among each other (technically called “retro ceding”), so compared to a “regular” life
insurance company, their number of insured lives is very large so they are able to base
underwriting decisions upon their own experience.
Recent studies indicate that about 75% of all applicants for life insurance that have
been declined have been declined for health reasons. Approximately 90 percent of
substandard ratings have been related to physical impairments, such as heart murmurs,
obesity, diabetes and hypertension (high blood pressure).
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RATING PROCEDURES OF IMPAIRED RISKS
The most common method used for substandard ratings is the multiple table extra
method, discussed above. Premium rates are based on mortality experience that
corresponds to the average numerical ratings in each class. Taking it one step further,
many companies use the same non-forfeiture values and dividends that they do for
standard risks – a few do not. Some companies do not permit the extended term option
on highly rated cases.
Companies vary premium rates for substandard risks by plan, with the extra substandard
premiums being lower for the higher cash value plans because the net amount at risk
decreases over the life of the policy so the insurer has less exposure. With the
exception of level premium plans, substandard premiums do not increase in proportion
to the degree of extra mortality expected, as the loadings in cash value policies do not
increase proportionately to the mortality risk. In other words, the expenses, such as
commissions, etc., do not increase significantly if a policy is substandard. It is typica l
for an insurer to pay commissions only on the standard premium and not on the
substandard portion of the premium. If commissions were to be paid on substandard
premiums, then the premiums would have to be raised to accommodate these
commissions.
 Table ratings reflect the extra mortality expected for individuals with the same
ratings. The substandard premium reflects a percentage of standard mortality, and
does not include loading or other expenses.
The following is an example of substandard mortalit y classifications:
Table
Mortality
(% of standard mortality)
1
125
2
150
3
175
4
200
5
225
6
250
7
275
8
300
10
350
12
400
16
500
Uninsurable Table 16 or rating over 550
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Numerical
Rating
120-135
140-160
165-185
190-210
215-235
240-260
265-285
290-325
330-380
385-450
455-550
FLAT EXTRA PREMIUM
The flat extra premium is used when the substandard risk is expected to remain static,
regardless of age, permanently or temporarily. A flat extra premium is added to the
regular premium and the policy is considered as “standard” for dividends and nonforfeiture values.
The flat extra premium is most commonly used for hazardous occupations and
avocations as the additional mortality risk is considered as static, regardless of age. It
is also used where the substandard extra risk is temporary in nature, such as after
surgery, or where there is a single health event, such as a coronary rating which
frequently consists of a table rating plus a temporary flat extra.
After a policy has been issued with a flat extra premium (or given a substandard rating
in a few situations) the insured may apply to have the extra premium removed if the
situation has changed for the better. If the extra premium was assessed because of
occupation, then a change of occupation could eliminate this extra premium. However,
the burden of change in status is the responsibility of the insured, and they m ust notify
the insurer of the change and be able to fully document this change. Usually when a
request for change involves occupation or avocation or change in residence, there will
be a probationary period of 1-3 years before the premium is lowered. This is obviously
a requirement so that an insured cannot revert back to the former occupation, avocation
or residence as soon as the extra premium has been dropped.
CONSUMER APPLICATION
Bristol Life Insurance Company was a small, relatively new, life insure r that relied
heavily upon services provided by their reinsurer. The Chairman of the Board and
principal investor in the company was 45 years old when he applied for a $1 million
face amount life insurance policy with Bristol because of a business arrange ment that
required that he be insured for that amount. Because of the size of Bristol, they would
keep (retain) only $50,000 on any one life, and therefore they sent the application to
their reinsurer for underwriting assistance.
The reinsurer’s underwriter requested an APS, which disclosed that the applicant had an
episode of hypertension where the blood-pressure readings were alarmingly high, about
3 years prior, but in two subsequent physical examinations, the blood pressure returned
to normal. The underwriter followed the typical underwriting guidelines for a single
episode of high blood pressure, which is to consider that a single episode will usually
become the norm – i.e., the applicant’s blood pressure will increase significantly, even
though it had not done so except for the one incidence. The application was declined
by the reinsurer, who, as required, submitted these findings to the MIB.
When the President of Bristol was notified that his Chairman had been declined, he
demanded a meeting with the reinsurance representative that serviced his company.
The political ramifications were immense, in his eyes. Not only could his company not
(Continued on next page)
173
insure the Chairman of the Board, but because of the MIB, he felt the “whole industry”
was aware of the problem and would not insure him. The reinsurance underwriter
stated he could reconsider this application if additional information could explain the
one-time high blood pressure reading. Otherwise they might agree to accept a $100,000
policy at increased premium, and with Bristol keeping $50,000. This, however, did not
solve the needs of the Chairman.
The applicant contacted his doctor who had made the readi ng. By checking the date it
was determined that on that day, the applicant, who was an experienced pilot who flew
single-engine biplanes, was in the cockpit of his plane, and his sister, also a pilot,
“spun” the prop on the plane to get it started. She f ell into the propeller, killing her and
her blood flew onto the cockpit. The applicant went into a state of shock, and his
doctor came to the airfield and took a blood pressure that was “off the chart.” That
accounted for the single episode of hypertension.
The reinsurance underwriter therefore agreed to accept the risk, but with a temporary
extra for a period of three years. If there were no more episodes of high blood pressure
during these 3 years, the rating would be removed. This was acceptable to a ll parties
concerned, and the rating was removed three years later.
(This example was taken from the files of a large reinsurer. Name of the writing
company has been changed.)
Companies usually provide a form at policy issue notifying the insured that af ter a
specified policy anniversary, they may submit evidence of insurability or other proof
satisfactory to the insurer, to have the rating removed. This helps to keep the policy
from being dropped if the insured is able to purchase standard insurance els ewhere
because of a change in their condition or situation.
MISCELLANEOUS RATING SYSTEMS
As mentioned earlier, the graded death benefit contract is a method of rating
substandard risks, as is the limited death benefit (for a period of 1 -3 years usually).
Before the table rating system was developed, it was common practice to limit the
amount of insurance in certain health situations. This had the same effect as increasing
the premium but was much less “scientific.”
Companies will often allow an individual who is not severely impaired to purchase a
permanent insurance policy as the company is obtaining the interest in premiums “paid
in advance,” or to put it another way, they are accumulating reserves which help to
soften the blow of an early death.
UNINSURABILITY
As discussed earlier, anything above a table 16 is, in most situations, uninsurable.
Many insurance companies, primarily the smaller companies, will only keep (retain)
risks that are lower than table 10 or 12, but issue the policies by using re insurance
facilities as most reinsurers will accept substandard applicants rated Table 16.
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Individuals who are uninsurable are often “desperate” as they realize that they may not
be able to leave their families with funds for them to continue their stan dard of living,
to say the least. An uninsurable individual can use annuities, if they have the funds, to
set up an “estate,” with tax benefits to the survivors.
Several years ago, it was possible for an individual to be accepted for credit life
insurance covering a loan amount, usually $10,000 maximum, but more in some cases.
This was a guaranteed issue situation, regardless of health. The philosophy of some
people that had good credit but were uninsurable, would be to borrow as much as
possible that would be covered by credit life and set the borrowed money aside to pay
off the loan. Therefore the “premium” for the life insurance would be the credit life
premium (and sometimes the lending institution would pick up some or all of those
premiums) plus the interest on the loan.
There is a documented case of an individual amassing $1 million in credit life
insurance, and since it was his practice to pay off each loan at the end of a year and
reinstate the full amount in a new loan, he was quite successful , leaving nearly $1
million in “paid-off loans” to his family when he died within 18 months after taking out
the loans. The credit life companies complained bitterly when this was discovered, but
there was nothing illegal about it at that time. Since that time, most states have issued
regulations that will not allow this abuse of the system.
A much better course for an un-insurable is to use a “substandard broker” who
specializes in getting insurance on the substandard risk. Some insurance companies
actually have arrangements with insurers who accept these substandard risks, so that
their agents can automatically rewrite the application into the other company.
Usually an uninsurable is an uninsurable, but many with high ratings can find insurance
if they search, or have their agent search, the market. A declination from one company
is not necessarily a declination from all companies.
REINSURANCE
Reinsurance is a specialized field and there have been textbooks written about the
subject, most of which is beyond the scope of this discussion. However, one should be
aware of how the reinsurers function if they are to really understand the insurance
business. It is safe to say that the life and health insurance would be completely
different in the number of policies offered, the issue of other than standard risks, the
number of insurance companies, the financial status of smaller insurers, the size of
insurance policies, and even, in many cases where a smaller or newer insurer is
involved, in the amount of commissions paid to the agents through financial reinsurance
arrangements.
One very important fact about reinsurance that should be kept in mind:
 There is no legal relationship between a reinsurance company and an insured.
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As discussed later, the reinsurance contract is only between an insurance company and
the reinsurance company.
Simply put, reinsurance is the transfer of all or a portion of a n insurer’s risk through an
insurance policy, to another insurance company – insurance of an insurance company, if
you will. But a reinsurer does so much more, as evidenced by the definition of
Reinsurance in the Dictionary of Insurance Terms, Third edition (Harvey W. Rubin,
Ph.D., CLU, CPCU) – “A form of insurance that insurance companies buy for their own
protection, a “sharing of insurance.” An insurer (the reinsured, ceding company, or
“direct writer”) reduces its maximum loss on either an individual risk or a large
number of risks by giving (ceding [“renting” or “leasing” is perhaps a more appropriate
word]) a portion of its liability to another insurance company (the reinsurer).
Reinsurance enables an insurance company to (1) expand its capacity; (2 )
stabilizes its underwriting results; (3) finance its expanding volume; (4) secure
catastrophe protection against shock losses; (5) withdraw from a class or line of
business or a geographical area, within a relative short time period; and (6) share large
risks with other companies.”
In all probability, all life insurance companies (worldwide) rely upon reinsurance. It is
truly an international business, as most of the life reinsurance on policies sold in the
United States and reinsured on one basis or another, is with foreign reinsurance
companies. The oldest reinsurers are a Swiss company and a German company (for
those who are curious, during WWII, the German reinsurers transferred their business
to non-German companies, and became more-or-less dormant until after the war). Most
reinsurance companies provide reinsurance for life and health exposures, and either are
owned by or affiliated with, a property and casualty reinsurance company. Some
reinsurers are reinsurance departments of “direct-writing” companies and at one time,
most U.S. reinsurance was reinsured by the reinsurance departments of large insurers,
such as Connecticut General, BMA, Lincoln National, Republic National, American
United, Security Life & Accident, etc. Most of the reinsurance business has been
transferred to “professional” (meaning they only do reinsurance, and is not a reflection
on the professionalism of other companies) reinsurance companies, most of them
foreign.
RETENTION
Retention is the amount of insurance that an insurance company is willing to accept in
its own account. The excess over the retention is reinsured, and this is how Collapsible
Life of Mississippi is able to compete with Metropolitan for a $1 million policy. (In the
Consumer Application previously shown, where a $15 million policy was issued, the
issuing company only had $25,000 retention. $14,975,000 was distributed among
reinsurers all over the world). If it were not for reinsurers, it is possible that there
would only be a half a dozen insurance companies in the U.S.
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The retention is usually determined by the actuary as it is a function of the company
surplus, i.e., what can the company stand to lose in case of a single death, without
impairing their surplus. Actually, when a life insurance compan y is formed, a rather
modest amount is kept by the company as there is no “spread of risk” or pool of
insureds to cushion a sudden death claim. It is to the company’s best interest to keep as
much as they can on their own books, as it costs the company to reinsure (reinsurers are
profit-minded companies). In practice, when a company is formed, the Board of
Directors makes the decision on how large a claim they feel comfortable paying,
without hurting the company or causing a stockholder rebellion.
A few – very few companies, used to pride themselves on the fact that they did not need
reinsurance as they had retentions of $1 million or more, and would not issue any policy
above that amount. Today, with so many new types of policies on the market, even the
very large company feels the need to spread the risk among reinsurers.
TYPES OF REINSURANCE
There are two “types” of reinsurance – proportional reinsurance and non-proportional
reinsurance.
PROPORTIONAL REINSURANCE
Proportional reinsurance refers to the arrangements where the reinsurer and the direct writing company share the risk and the premium on some sort of pre -determined
contract. Most reinsurance falls into this category.
NONPROPORTIONAL REINSURANCE
Non-proportional is the simplest (by concept) type of reinsurance. In these
arrangements, the reinsurer pays a claim only when the amount of the loss exceeds a
predetermined loss limit. The effect of this type of reinsurance is to stabilize the claims
of the direct-writer.
There are three forms of non-proportional reinsurance.
STOP - LOSS REINSURANCE
The direct-writer determines the total amount of claims that it can sustain (or wants to
sustain) during a year. The reinsurer then pays for the claims above that amount.
Premiums usually are adjusted annually to reflect actual claims experience. While this
form or reinsurance is simple, it has not worked well to any degree as insurers that have
tried this, almost always will practice a form of adverse selection with the reinsurer.
The direct-writer will become more “flexible” with their acceptance of risks – after all,
if they have too many claims the reinsurer will pay for the direct -writers mistakes. In
property and casualty, it called “Excess of Loss Ratio” and as the President of a large
property and casualty reinsurer stated at an industry meeting, “the fields are covered
with the remains of reinsurance executives who promoted Excess of Loss Ratio
reinsurance treaties.”
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CATASTROPHE REINSURANCE
This is a common and successful type of reinsurance, where multiple insured losses
which arise from a single accident or incident are covered. Many insurance companies
have catastrophe reinsurance, particularly where they have a large concentration of risk,
such as writing a lot of group or travel insurance.
SPREAD-LOSS REINSURANCE
Spread-loss is similar to Stop-loss, except if there are claims with the reinsurer, the
claims are spread over a specific number of years which then allows the ceding
company to spread its losses over several years.
REINSURANCE CONTRACTS
The reinsurance contract traditionally is called a “treaty” and in the transfer of risk
under proportional reinsurance, there are two types of treaties.
FACULTATIVE TREATY
Facultative reinsurance is a method of reinsuring where each application is
underwritten individually and reinsured individually. The reinsurer may or may not
accept the application (risk), may rate the policy because of health or other reasons, or
may accept it on the same basis as that of the ceding company. (As discus sed in the
previous Consumer Application)
The ceding company may keep a retention on the case – which may vary by table rating
– or cede the entire amount. Facultative cases are many times submitted to a reinsurer
in order to obtain the expertise of the reinsurance underwriting department (which are
well-experienced and technically trained, including a medical underwriting department),
and after the reinsurer has rendered its decision, the ceding company decides how much
of the policy they will keep, if any.
The ceding company may submit the case to more than one reinsurer simultaneously or
later if it wishes. If the amount is large, the reinsurer may reinsure some of the policy
with another reinsurer (this is called a retrocession), or if the reinsurer is unable to find
another reinsurer willing to accept part of the risk, then the reinsurer may restrict the
amount it is willing to accept.
The disadvantages of facultative reinsurance is that it takes time to do all of the
underwriting, particularly since most of them involve medical records, and therefore the
applicant may purchase insurance elsewhere. Also, it costs money to reinsure, so there
is less profit for the ceding company.
AUTOMATIC TREATY
The Automatic Treaty requires the ceding company to reinsure a portion of all of its
reinsurance in excess of its retention at the time the policy is issued, and the reinsurer
must accept the reinsurance.
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The treaty allows the ceding company to “bind” the reinsurer for only a certain amount
on each life (a “cap”) – usually a multiple of the company’s retention, such as “threetime retention” - and there can be an agreement to distribute the excess to another
company – usually a reinsurance company, but not necessarily. Many direct -writing
insurance companies use more than one automatic reinsurer, and traditionally the
business is split on an alphabetical basis. For instance, all surnames starting with
letters A through M go to one reinsurer, those with letters N through Z go to another
reinsurer (it may be split more than 2 ways by dividing up the alphabet, but generally,
two automatic reinsurers are all that a ceding company wants, for administrative
reasons, unless the ceding company has an unusually large amount of reinsurance).
The automatic treaty does affect the facultative treaty(s) as those cases are usually
excluded from the automatic treaty. Some automatic treaties may require that they see
the facultative cases also, but at the same time, allow other companies to review them
also.
FACULTATIVE OBLIGATORY
A “cross-breed” type of treaty “obligates” the ceding company to submit all facultative
business to the reinsurer, who then reviews the case and may or may not accept the
policy. Some of these treaties allow the ceding company to place the policy with the
facultative-obligatory reinsurer if any other reinsurer has made a “better offer” on the
case, in which case the “fac-ob” reinsurer must accept that underwriting decision also.
But generally the ceding company must keep part of it also.
To reiterate
 A policyowner must look only to the direct-writing company for any payments that
the policyowner is entitled to under the policy. The direct -writing company is
responsible for these payments, regardless of the types and terms of any
reinsurance agreement between the insurer and reinsurer.
REINSURANCE PLANS
There are three types of reinsurance plans that can be used for either automatic or
facultative reinsurance.
YEARLY RENEWABLE TERM (YRT)
Yearly Renewable Term is used almost exclusivel y for facultative reinsurance, and for
most automatic treaties. Under the YRT basis, the ceding company reinsures the net
amount at risk of the reinsured amount, paying the premiums from a table of
reinsurance premiums (broken down by age, sex and table ratings). As the reserves
increase each year, the net amount at risk decreases, until eventually the ceding
company would “recapture” the entire amount. The treaties usually establish a
minimum time period for the reinsurance on each case to be in effect, after which the
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company can start “recapturing” reinsured policies, thereby reducing their reinsurance
costs. The YRT premiums are completely different and separate from those premiums
charged by the direct-writer to its customers as the reinsurers do no t have to establish
reserves and they do not have the expenses – particularly first year commissions – of
the ceding company.
COINSURANCE
As the term implies, each individual case is “co-insured” which is accomplished by the
ceding company and the reinsurer sharing a proportionate part of each risk, and under
the terms of the policy. The reinsurer then becomes liable for death claims which are
determined by the size of the policy in relation to the percentage reinsured.
If, for instance, the reinsurer is responsible for one-half of each risk, in case of a death
claim the reinsurer pays for ½ of the claim. For this service, the reinsurer receives a
certain percentage (pro-rata share) of each original premium, less an agreed-upon
amount for a ceding commission and allowances (used for agent’s commissions and
other expenses, sometimes for premium taxes also, but generally they are paid to the
ceding company separately each year).
The reinsurer must establish the necessary reserves on the amount that is re insured;
therefore the ceding company must pay the increase in reserves on the amount reinsured
each year, to the reinsurance company.
MODIFIED COINSURANCE
Coinsurance has worked for reinsurance for decades; however companies started asking
why they could not keep the reserves for investments, themselves? Under the Modified
Coinsurance plan, the reinsurer pays to the ceding company a “reserve adjustment” each
year which is equal to the net increase in the reserve during the year, less one year’s
interest on the total reserve held at the beginning of the year (as otherwise the reinsurer
would not be receiving any interest on funds held, which is an important part of the
profit). The effect of this arrangement is that the ceding company receives the bulk of
the funds developed by its policies.
ASSUMPTION REINSURANCE
Policyowners and Life insurance agents may be familiar with this transaction if a
policyowner has ever received a notice that thereafter they would be insured by another
company. Unfortunately, sometimes the policyowner will become upset and change
companies or just cancel the insurance policy as they do not know exactly what is going
on. If the reason for the assumption is the financial difficulties of the original
company, policyowners can start to doubt the financial stability of the entire industry.
A professional reinsurance company would not be involved in assumption reinsurance
as far as the policyowner is concerned, but it is method of transferring insurance
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business from one insurer to another. Many insurers have made the decision to
withdraw a policy form or from a geographical area. Assumption reinsurance has also
been used when an insurance company suffers financial difficulties and goes into
receivership. Many times, the Department of Insurance will dictate the transfer of
business or will agree to the transfer.
Policyowners must be notified prior to such assumption, and under an NAIC model bill
covering assumption reinsurance, a policyowner has a right to consent to or reject the
transfer of their policy for a period of 25 months. Some states have shortened this
period from 30-days (Washington) to 12 months (Missouri).
SURPLUS RELIEF
Surplus relief is a technical method of financial reinsurance, where the principal object
of the reinsurance arrangement is not just to transfer risk, but in effect, to finance the
writing of new business or otherwise the development of the company. This method is
used if a smaller company wants to write a lot of new policies, and the coinsurance or
modified coinsurance agreement (which reinsures only newly written business) does not
help the surplus drain sufficiently, and where the company has a block of business in
force.
The technical aspects of this type of reinsurance is outside the scope of this text but
basically, the reinsurer evaluates the profitability of the block of business, and in effect,
“leases” the block of business, paying the direct -writing company commission and
expenses equal to the anticipated profits on the block of busin ess (less the reinsurer’s
profit). This frees up funds that the ceding company can use to develop new business.
Later, the ceding company may make enough profit on the new business written, or use
the rapid growth of the company to entice new stockhold ers, or in some other fashion
attain enough funds so that they can recapture the reinsured block of business and pay
the reinsurer a reasonable amount for the use of the reinsurer’s money during that time.
This form of reinsurance has its critics who fear that insurers are “propping up”
impaired companies and “forestalling the inevitable” as the company finally goes into
receivership, leaving the Department of Insurance to scramble around to find a company
that will assume this business (and the formerly-reinsured block does not have much
profit left). However, there are substantial companies that have used this type of
reinsurance to allow them to explore new areas and keep up with their “better -heeled”
competition.
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STUDY QUESTIONS
Chapter 9
1.
2.
3.
4.
5.
6.
“Underwriters” or “home office underwriters”
A.
are individuals that do the risk selection and classification.
B.
are individuals who market life insurance.
C.
deal with certainties.
Individuals who are in good health are considered
A.
a substandard risk.
B.
a standard risk.
C.
are the only individuals that apply for life insurance.
Adverse selection
A.
starts when an applicant is uninsurable.
B.
keeps life insurance premiums high for all insureds.
C.
stops the “substandard risks” from obtaining life insurance.
A factor primarily used in the home office underwriting process is
A.
the spouse’s occupation.
B.
the size of the applicant’s house.
C.
the applicant’s physical condition.
The reputation of the applicant in meeting financial obligations
A.
is not part of the underwriting process.
B.
only shows that the applicant can pay the premiums.
C.
can indicate the moral risk involved with the applicant.
If the applicant discloses that he/she goes sky diving on the weekend, the insurance
company
A.
will issue the policy at the standard rate.
B.
many times will add a flat extra premium.
C.
will not know about it.
182
7.
8.
9.
10.
11.
12.
The first source of information, about the applicant, the underwriter looks at is
A.
the application.
B.
inspection reports.
C.
the Medical Information Bureau (MIB).
Authorization to release information to the Medical Information Bureau (MIB)
A.
can be obtained over the phone.
B.
must be in writing.
C.
comes from the applicant’s insurance company.
If an applicant does not meet the underwriting criteria of Insurance Company A
A.
the applicant can be denied.
B.
the applicant can apply to Insurance Company B without telling them about
Insurance Company A .
C.
will inform the Medical Insurance Bureau (MIB) the application was denied.
Reinsurance creates a relationship between the reinsurance company and
A.
the insured.
B.
the “direct writer” insurance company.
C.
the life insurance policyowner.
A field underwriter
A.
is an individual who sell life insurance.
B.
determines what the premium should be for a specific risk.
C.
decides if an applicant is insurable.
The home office underwriter considers and applicant’s __________________, as an
important factor when considering an applicant for life insurance.
A.
address.
B.
favorite sports team.
C.
physical condition.
183
13.
14.
15.
The use of tobacco by an applicant
A.
means the applicant is uninsurable.
B.
may cause mortality experience to worsen.
C.
will result in lower premiums.
Once an individual is “rated” because of their occupation
A.
they will always pay the higher premium.
B.
a change in jobs will not affect the premiums.
C.
their premiums are higher than an individual in a non-hazardous job.
Information used in underwriting
A.
only comes from the applicant.
B.
can come from the application.
C.
can, without authorization be shared with other..
Answers to Chapter Nine Study Questions
1A 2B 3A 4C 5C 6B 7A 8B 9A
10B
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11A
12C
13B
14C
15B
CHAPTER TEN - INSURANCE REGU LATION AND ORGANIZATION
According to the United States Constitution which recognized that the free flow of
commerce between states would be jeopardized by trade barriers between the various
states, gave Congress the power to regulate commerce between th e states and with
foreign governments. The power to regulate commerce within the states (intrastate)
was reserved for the states. However, no state can exercise authority over an area
designated as being under the jurisdiction of the federal government. Insurance has
traditionally been regulated by the states.
In 1869, in a case (Paul v. Virginia), the U.S. Supreme Court did not agree that an
insurance policy is an item of commerce. Also, they stated that a state has the authority
to prohibit foreign insurance companies from doing business with the state. They
stated, “Issuing a policy of insurance is not a transaction of commerce.” They looked
upon insurance policies as any other contract between persons which are not interstate
commerce, even if the people resided in different states. They ruled that insurance
companies are governed by state law and do not “constitute a part of the commerce
between the states.”
Up until 1944, the accepted practice was for insurance to be regulated solely by the
states. However, the U.S. Supreme Court ruled in the famous “South -Eastern
Underwriters case (United States v. South-Eastern Underwriters Association, et al.) that
insurance was indeed “commerce” and therefore could be regulated by the Federal
government. This opened up the insurance industry to regulation by states and/or
federal laws, including those already enacted that could be applied to insurance.
The Congress quickly recognized that there must be some order in the regulatory
process, so in 1945 they enacted the McCarran-Ferguson Act which revisited the
authority of the states and which provided a plan for cooperation in regulations between
the federal and state government. This act allowed the federal government to retain
control, either solely or primary, of certain matters that they determined was national in
character, such as the National Labor Relations Act, the Civil Rights Act, the Fair
Labor Act, and the Sherman Act, to name a few.
Furthermore, (and a very important “furthermore”) Congress w as allowed to expand
their regulation of insurance by passing specific legislation which would apply directly
to insurance. Since that time, other legislation provided some insurance elements to be
under federal regulations, such as amending the Securities and Exchange Act in 1964 to
cover insurance, and other regulations concerning flood insurance, crop insurance, and
more recently, Medicare.
Actually, the principal purpose of this act was to encourage more and better (and
uniform) state regulations or insurance. This was done by the law stating that certain
federal laws which are general in nature (i.e. do not specifically apply to insurance) are
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made “specific” to the business of insurance to the extent that “such business is not
regulated by state laws.”
Following the enactment of the McCarran-Ferguson Act, the National Association of
Insurance Commissioners (NAIC) with the readily-available assistance of the insurance
industry, created “Model” legislation. This was politically important for the stat es to
have more uniform and easily-understood regulations, but in actuality, it was to
reinforce the “provision” of the McCarran-Ferguson Act as stated above.
Today, the states still maintain primary responsibility for regulating insurance within
their states, but the adequacy of state regulation comes under almost continual scrutiny.
In 1965, the Health Insurance Association of America, at their annual convention, felt
that their very existence had been assaulted by the introduction of the federal progra m,
Medicare, but they had to grudgingly admit that since they had not been successful in
providing health insurance to the senior citizen population at affordable costs, it must
be expected that Uncle Sam would step in. (Even though the Medicare regulatio ns
allowed insurers to offer “Supplemental” policies, the federal government felt that they
had to step in again and a later date, and create uniform Medicare Supplemental policies
and affected regulations which bound all insurance departments and insuranc e
companies to abide by a strict uniformity.)
There are many arguments for or against state or federal regulation of the insurance
industry.
Some of the arguments that favor state regulation are: there are already state
regulations, states can be more responsive to local requirements and needs, the
decentralization of government should always be a goal of industry, etc.
Some of the arguments in favor of federal regulation are: it is expensive for insurers
(costs are passed to the policyowners) to have to file reports with various states, and
abide by different (and sometimes, opposing) regulations, insurance commissioners are
often overly responsive to requests by local insurance companies, federal regulations
would eliminate conflicts between state regulations, many companies now have foreign
ownership or interests and states cannot deal with foreign governments on an efficient
basis, etc.
FE D E R A L R E G U L A T I O N
The federal government exercises its authority in an unusual fashion. Periodically and
depending upon the political climate, Congress will hold hearings and otherwise
“investigate” the insurance industry on matters of recent interest. By doing this, the
federal government is sending a message to the states that the problems investigated,
either real or imagined, need regulation by the states or the federal government will step
in and fulfill (what they consider) their responsibilities.
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Of course the Internal Revenue Service exercises considerable authority over insurance
companies and insurance products and their design and values through tax laws and
regulations. In addition, the IRS also influences the demand for insurance and the
taxation of the insurance companies.
The Employee Retirement Income Security Act (ERISA) of 1974 probably has had mo re
influence on insurance products and marketing than any other specific federal
involvement in the insurance industry. ERISA was passed in 1974 and was originally
designed to protect pension-plan funds against raids by unscrupulous labor leaders. It
promulgated regulations that safeguards retirement funds, but it also included a clause
which preempted any state laws from regulating certain employee benefit programs,
including health insurance. This act is considered by many as an unwarranted intrusion
of the Federal Government into the business of insurance.
The Securities and Exchange Commission oversees the design, operation and the
marketing of variable life and annuity products. Insurance companies that are publicly
owned must file with the SEC, and the sale and issuing of stock of these companies are
very much under the direction of the SEC.
One of the most severe critics of the life insurance industry in recent years, has been
the Federal Trade Commission (FTC) and unfortunately, it exercises va rious degrees of
supervision over insurance activities. It still is involved in the oversight of direct -mail
insurance solicitations. In the 1970’s, it was very much involved in congressional
hearings in life insurance and marketing disclosures. In 1979 the FTC investigated life
insurance marketing and issued a controversial report that included detailed
recommendations as how to solve the reported consumer problems. This report was
strongly contested by the insurance industry and the FTC has been rath er quiet on this
front in recent years, especially since the enactment of the NAIC Model Unfair Trade
Practices Act (see discussion of NAIC Model bills later in this text).
Other federal agencies become involved with the insurance industry when insurers w ork
with foreign insurers. NAFTA, for instance, provides that there shall be (relatively)
free access between the insurance markets of the U.S., Canada and Mexico, and it
prohibits discrimination between domestic and foreign insurers of those countries.
The federal government also becomes involved in the insurance business through the
Bank Holding Company Act which determines and controls the extent that banks can
become involved in the insurance business. There was, and still is, considerable
concern in the insurance industry as to the competition that could arise if banks have
more authority to enter the insurance business. Banks and financial institutions have
not only names of their customers, but personal financial information not available to
others, that would give a tremendous advantage to banks. Regulators are very much
aware of this. However, as a practical matter, bankers have been notoriously incapable
of marketing effectively – an area of expertise held by insurance companies – so many
experts believe that the threat of financial institutions, particularly banks, is not as
strong as it may appear to be. Be that as it may, banks have done a respectable job in
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marketing certain annuities and as insurance companies become more aggressive in
financial products areas, the differences between financial institutions and insurance
companies will diminish.
STATE REGULATI ON
State legislatures issue laws pertaining to the regulation of insurance companies within
their jurisdiction, such laws called insurance codes. These laws involving state
regulation are described in more detail below, but basically they cover the make -up of
the insurance department, licensing of companies and agencies, the filing and approval
of insurance forms and rates, and many other areas involving the financial strength of
the domestic companies.
The state courts are very involved in insurance, as they are usually the final arbiters of
conflicts between insurance companies and their policyowners. Not only do they
punish those who violate the insurance laws, but they are used by insurers and agents on
occasion to overturn certain statutes or regulations that may be arbitrary or
unconstitutional.
Within each state, there is a Department of Insurance that is under the direction of the
state Insurance Commissioner. The Insurance Commissioners are usually appointed by
the Governor, but in a dozen states, they are elected. In some states, they have
additional responsibilities, such as state auditor or fire marshal, or the departme nt is
associated with other departments such as banking or securities. The control of the
insurance industry in the state is accomplished through the issue of licenses – from the
selling agent to the insurance company. Through licensing, they also contro l the
activities of those foreign companies who are not under the direct control of the state
regulatory bodies.
THE NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC)
The NAIC is an association of the Insurance Commissioners of the states and U.S.
possessions (American Samoa, Guam, Puerto Rico and Virgin Islands). Their stated
purposes are to maintain and improve state regulations, ensure reliability of insurers as
to financial solidity and financial guaranty, and the “fair, just and equitable” trea tment
of policyowners and claimants.
This Association is comprised of a number of committees which are broken down by
line of business, i.e. life, health, property/liability. These committees depend heavily
upon the advice, expertise and knowledge of those in the insurance industry and many
insurance executives and technicians belong to various advisory groups. Of course,
consumer groups criticize this format by insisting that the regulators are “in the hip
pockets” of the insurance companies.
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One of the most important decisions of the NAIC has been the introduction of “Model”
regulations, which are bills and regulations agreed upon by the NAIC members as being
worthy of consideration by all states. The models have no particular authority, but the
NAIC just suggests that the various states adopt the models. In most cases the majority
of the states do adopt the models either in their entirety or with modest changes to
reflect the individual states political atmosphere.
The NAIC, as a matter of self-preservation, has accomplished considerable
standardization of forms and solvency requirements. They also created scheduled and
unscheduled insurance company examinations by teams of auditors assigned to the
particular zone in which they are located. These examinations have uncovered many
situations that could have cost policyowners and stockholders of insurance companies
dearly. Most possible insolvencies of insurers have been discovered through this
examination procedure.
The NAIC does a creditable job in policing itself through a method of state
accreditation. In fact, those states which are “accredited” do not accept examination
reports from states that are not accredited on examination of their domestic insurers and
the companies that are domiciled in states that are not accredited, must obtain a second
examination from an accredited state. Since the insurance companies pay for their
examinations (and which can become quite expensive) this creates considerable
pressure on the insurance department to become accredited. This system of
accreditation has been subjected to a lot of criticism, but the NAIC insists that any such
criticisms are either premature or unfounded – and after all, the opinion of the NAIC is
the only one that counts.
SUPERVISION BY STATE REGULATIONS
The principal purpose of state regulation is that of solvency of insurance companies.
There are limits as to the size of risks that insurers can assume, and there are specific
requirements for capital and surplus amounts for insurers, reserve liabilities on policies,
and regulation of the investments of the insurance companies. The state insurance
department also is responsible for the liquidation or conservation of insurance
companies that operate within their jurisdiction. Thanks to this responsibility, financial
losses to policyowners because of failure of insurance companies in the United States
have been miniscule.
State insurance laws dictate the requirements for organizing and licensing of insurance
companies, and life insurance companies have their own special requirements. It is
interesting that health insurance can be written by a life insurance company, a health
insurance-only (monoline) company, or a casualty company, and a new health insurer
can be organized under the laws governing the organization of life or casualty insurance
companies.
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There are three different types of insurers regulated by the insurance departments: (1)
A domestic insurer is domiciled in the regulated state; (2) a foreign insurer is an
insurance company which is domiciled in another state or territory; and (3) an alien
insurer is an insurance company which is domiciled in another country. The licensing
requirements for the various types of companies are similar, as they are all required to
maintain specified assets within the regulated state. A foreign insurer often places
assets in deposit with the insurance department of their state of domicile, and a
certificate to this effect is given to the department of the regulated state. An alien
insurer, on the other hand, is usually required to establish a more substantial fund or
deposit in trust in the regulated state. They must also assign a resident of the state in
which it wishes to do business, to serve as its attorney in case of legal matte rs or legal
process.
There is a continuing perplexing problem for insurance department, involving the
activities of unauthorized insurers. Since they do not file financial statements with the
department of insurance, and since their business is usually c onducted through the mail
or more recently, over the internet, the insurer attempts to escape regulation. However,
the states may take certain actions, some of which involve insurance agents.
 The NAIC Unauthorized Insurer Model Statute states that no pers on can solicit
business or become involved in any fashion, in the transaction of insurance from
unauthorized insurers, and further, they cannot represent any person in procuring
insurance from an unauthorized insurer.
 Usually, group life and health insurers are excluded from this Model act, but the
NAIC recommends that the life and health insurance policies, usually sold
through mass-marketing techniques, still be subject to advertising and claim
settlement practices and meet minimum-loss-ratio guidelines that are in effect
for authorized insurers in that state.
 To tighten up a little more, some states prohibit any advertising originating from
outside of the state designed to sell insurance to the residents of the regulated
states and some states allow the insured to legally void the contract (although
that is frequently “closing the barn door…”). Further, in many states, an insured
can bring legal action against an unauthorized insurer by serving process on the
insurance commissioner of the insured’s state.
 Obviously, health insurance policies are the type of plans that cause more
problems to the insurance departments so some states, a growing number of
states in fact, have passed legislation that allows the assumption of jurisdiction
over uninsured or partially insured multiple employer trusts or other trusts.
States require that policy forms may not be used within their jurisdiction until it has
been filed and subsequently approved by the regulating state. The states make their
requirements known and in most cases they contain some “model” provisions, such as
grace period, incontestability, entire contract, misstatement of age, dividends, surrender
values and options, policy loans, settlement options and reinstatement. There are
certain standards that must be met, such as that the policy forms must not be ambiguous
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or misleading, or encourage misrepresentation. Some states follow the model law that
states that policy forms may be disapproved if benefits are unreasonable in relation to
the premium for the policy.
Some states, in addition to state laws, issue administrative bulletins or guidelines,
which, to all practical purposes, assume the legality of insurance codes, although they
deal generally with administrative matters primarily.
Even though the model law requires some relationship between premiums and risk, as
mentioned above, life insurance premiums are not regulated except that states establish
minimum reserve requirements which would therefore affect the rates as the insurer
would need to receive adequate premiums in order to have funds to post the required
reserves. Also, insurance companies file annual reports which provide the department
with the administrative costs of the insurer. New York and Wisconsin have very
complex and demanding laws limiting the amount of expenses that can be incurred in
insurance production, thereby limiting commissions on certain products and expenses
on existing business.
Some states also limit the amount of dividends that may be declared, particularly by a
stock insurer. Most states simply believe, and it have been proven correct, that
competition is the most important regulator of insurance premiums.
No person can act as an agent or broker, and in some cases, fee -paid counselors,
without first obtaining an insurance license. Requirements for licensing differ by state,
but in general, there must be successful completion of a written examination for the
particular license. Each agent must be appointed by an insurance company, who
notifies the department of insurance as to the persons appointed by them.
An insurance license can be refused or revoked, or suspended, by the insurance
department (after notice has been served and a hearing held) because of
 incompetence or untrustworthiness,
 fraudulent or dishonest practices, or
 committing a violation of the law while acting as an agent.
Because of the South-Eastern Underwriters Act and the McCarran-Ferguson Act, all of
the states adopted the NAIC Model Unfair Trade Practices Act. It should be noted that
this Act was so thorough that it replaced the FTC jurisdiction in these matters, as
mentioned earlier. This act gives the Insurance Commissioner power to investigate
&/or examine companies, hold hearings on the companies transgressions, and issue
cease-and-desist orders with penalties for violations.
Rebating is one of the actions addressed by this Act, and which is defined as an agent
returning any portion of his commission as an inducement for an applicant to purchase
insurance from him. Historically, it has been illegal, however there are those critics
who feel that these laws preventing rebating prevents purchasers of insurance from
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negotiating with the sellers of insurance completely. Florida and California do now
allow rebating, but with very strict guidelines, and with provisions that there is no
unfair discrimination in the granting of rebates, i.e., an agent cannot “pick -and-chose”
when and to whom they may offer rebates.
Twisting, which is where an agent or broker attempts to persuade a life insuranc e
policyowner to cancel one policy and buy a new one by using misrepresentations, is
obviously illegal and can cause an agent to quickly lose their license. Replacement, on
the other hand, is legal, and is simply replacing one policy with another. Most st ates
have laws that require full disclosure of relevant comparative information about
existing and proposed policies by an agent trying to convince a customer to switch
policies. These laws may provide for notification of the insurance company that issued
the existing policy to give it an opportunity to respond to the agent’s proposal. States
are quite specific about what information must be disclosed when one policy is
discontinued so that another policy may be substituted.
Agents are also tightly regulated in respect to handling of funds that belong to
policyowners, Misappropriation of funds or misusing funds, is illegal, even on a
temporary basis. Also, agents are not allowed to commingle funds, or combine money
belonging to policyowners with their own funds. Agents that handle large sums of
money in their business are well advised to make sure that under no circumstances, do
any funds that belong to the policyowners find their way into an account holding an
agent’s personal funds.
Another model act is the NAIC’s Model Life Insurance Advertising Regulation and it
has been quite widely accepted in regulating the advertising of life insurance. This
regulation governs the form and the content of advertisements, including minimum
disclosure requirements, and it provides for enforcement procedures by the insurance
departments.
FINANCIAL REGULATION
Every state requires that a financial statement be filed with the insurance department in
each state in which the company is authorized to do business. These financial
statements (called “blue books” for life insurance companies as their binders are
traditionally blue, while those of non-life companies are other colors) are filed at least
annually, and may be required to file more frequently if the insurance de partment
requires it for solvency matters.
Insurance departments distinguish insurance company funds as either Capital &
Surplus, or Reserve investments. Capital & Surplus funds can be invested in certain
types of investments, such as cash, government bonds and mortgages. The Reserve
funds may be invested in other capital investments. No company may make any
investments without approval of the Board of Directors, or a committee authorized by
the Board to make such investments with appropriate minutes for review by the Board.
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Valuation of these assets held by the insurance company is a very complicated and
detailed procedure, and the valuations are performed according to the Securities
Valuation Office of the NAIC. Some states require that a certain a mount of assets be
allowed to be invested in certain types of funds or assets, and some simply allow the
company to invest according to a prudent-person rule. For instance, in New York, an
insurer may hold up to 10 percent of its assets in a Canadian inve stment, but no more
than 3 percent in securities from any other company.
Res erves
 The Prospective Reserve is the amount designated as a future liability for life (or
health) insurance to meet the difference between future benefits and future
premiums.
To further illustrate, a Net Level Premium is determined so that this basic relati onship
holds: the present value of a future premium equals the present value of a future
benefit. This relationship exists only at the time that the policy is issued, and
afterwards, the value of future premiums is less than the value of future benefits
because fewer premiums are left to be paid. Therefore, a reserve must be maintained at
all times to make up this difference. Life insurers are required to establish minimum
reserves as established by an attested to by an actuary under state guidelines, a s a
liability.
The actuary of the insurance company must file a report wherein results of certain cash flow testing results are required. This report, along with a required annual CPA report,
allows insurance departments to receive a good financial overv iew of each insurer in
their jurisdiction.
The insurance departments use the NAIC’s Insurance Regulatory Information System
(IRIS) as an early warning measure if an insurance company is heading towards
financial difficulty. This is a 2-pronged attack, as the financial reports of the company
are analyzed according to pre-determined guidelines and minimums. Then auditors
from various insurance departments, analyze the annual statements and other financial
information. This information is given to the insurance department of the state of
domicile for future action.
The state insurance departments can address any problems in their state of a potentially
fraudulent nature and take action through administrative sanctions and/or civil actions,
such as cease-and-desist actions, license suspension or revocation, or injunctions. The
insurance departments have a special activities database which allows the states to
exchange information as to the activities of insurance companies and personnel.
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LIFE AND HEALTH GUARANTY ASSOCIATIONS
Every state has some type of guaranty law that gets its funding from assessments
against (solvent) insurers that operate in their state. The NAIC Model Guaranty
Association Act of 1985 (and amended several times) differs from state -to-state
application. Generally, the association is under the supervision of the Insurance
Commissioner, and the act covers policyowners who are residents of the state where the
insurance company is determined to be insolvent or impaired. Beneficiaries o f the
insurance are covered, regardless of where they reside.
A maximum of $300,000 in life insurance death benefits will be paid, but not more than
$100,000 in net cash surrender values. For annuity cash values and payments
(including tax-qualified annuities and structured settlements) coverage is limited to
$100,000. (NOTE: This the same amount that is protected by the FDIC on CD’s and
bank accounts.) If the insurer fails, the guaranty association will protect the account up
to this amount. Regardless, one is hard pressed to recall an instance of an annuity
holder losing other than anticipated interest growth, as the principal was always
maintained. As a note of interest, health insurance maximum payments are $500,000
for medical expenses covered, $300,000 for disability income, and $100,000 for all
other health insurance coverages.
NOTE: These limits apply to an individual insured and not on a per-policy basis. If an
annuitant had 2 or more annuities with an insurer, the maximum amount of $100,000
would apply, regardless of how much cash value an insured would otherwise receive.
The guaranty association funds have weaknesses, and coverage is not uniform among
the states. There always exists the hazard of a large insolvency where the assessments
of all of the companies in the state might not meet the requirements of the association.
TAXATION O F LI FE INSURANCE COMPANIES
Life and Health insurance companies in the United States are taxed by the federal and
state governments. The states subject insurers to premium taxes which is simple in
administering usually as the premiums received from the policyowners are taxed, with
certain exceptions, such as dividends and assumed reinsurance. Certain health insurers
are typically exempt from state taxation, such as Blue Cross and Blue Shield in some
states, however this is changing and most of them are now being taxed as any other
health insurer.
Many consider the state premium tax to be one of the most unfair taxes levied on U.S.
citizens, with very good reasons.
 Only insurance companies are taxed directly on savings.
 It hits lower-income persons harder than higher-incomes person (regressive tax).
 There is discrimination against cash value life insurance which is, by its nature,
higher priced, and the tax is levied against the premium amount.
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 Elderly and Substandard insureds must pay a higher percentage of tax as their
premiums are higher.
 The premium tax must be paid regardless of how profitable or unprofitable the
insurer is.
States also levy various forms of taxes, such as income taxes (9 states, but 8 of these
states allow offset of premium and income tax). There are also Retaliation Laws that
taxes out-of-state insurers operating in its jurisdiction in the same way that the state’s
own insurance companies are taxed in the second state. (For example, one state (#1)
charges 4% premium taxes on its domiciles insurers. However, if these insurers are
charged a higher tax when operating in another state (#2), then state #1 will charge the
higher tax to insurers of state #2 who wish to do business in state #1)
FEDERAL TAXATION
Life insurance companies in the United States are taxed under the Deficit Reduction Act
of 1984 and they are taxed on their life insurance taxable income (LICTI), which is the
gross income less certain deductions, similar to any other corporations, but with certain
differences.
For tax purposes, “gross income” of a life insurance company is divided into 5
categories:
1. Premiums
2. Investment Income
3. Capital Gains
4. Decreases In Reserves
5. All Other Items Of Gross Income
The Internal Revenue considers as income all premiums and considerations received on
insurance (or annuity) policies, which include any fees (such as policy fees), deposits,
assessments, prepaid premiums, reinsurance premiums and the amount of any
policyowner dividends reimbursable to the insurer by a reinsurer. (Reinsurance
premiums and reimbursed dividends by a reinsurer are considered to have been taxed
previously. If an insurance company must pay premium tax on business th at has been
reinsured under certain treaties, the usual practice is for the reinsurer to reimburse this
amount to the ceding company.) Premiums or deposits on supplemental contracts and
similar sources of premium are considered as gross income. This cate gory of gross
income is about 60 to 80% of taxable assets of an insurer.
1. The investment income from interest, dividends, rents and royalties which consists
of 20 to 40% of the gross income of a life insurer, is taxed.
2. Life insurers are taxed on capital gains the same as other corporations.
3. Net decreases in insurance (certain specified) reserves produce an income item that
is taxed. This may seem “backward”, but life insurance companies are allowed tax
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deductions when net additions are made to reserves. Therefore, when the reserves
are released, this release produces an income item for the company.
4. And of course, there is the inevitable catch-all provision. The IRS leaves no stone
unturned when determining a source of income for the government.
Life insurance companies are allowed three types of deductions:
 corporate deductions
 deductions “peculiar to the insurance business”
 the small life insurance company deduction
Life insurers are allowed the same deductions as general corporations (expenses of
operations, benefit plans, etc., etc.). Those expenses that are peculiar to the life
insurance business, which, simply put, are deductions for all claims, benefits and losses
incurred on insurance and annuity contracts. In addition, there are deductions allowed
for certain insurance reserves, such as policy reserves, unearned premium reserves,
unpaid loss reserves, advance premium and other similar reserves. Policyowner
dividends are another deduction, subject to strict rules.
The small company deduction is a deduction (created for political purposes) that was
created to stimulate and to assist new and small businesses. This deduction is a
maximum of 60% of the LICTI not to exceed $3 million, or a maximum deduction of
$1.8 million (60% of $3 million).
TAXATION OF DIVIDENDS
For many years, mutual insurance companies had a distinct tax advantage over stock
companies. Mutual companies often charge higher premiums than stock companies, and
then return the excess amount to the policyowner in “dividends.” However, also
included in these dividends are distributions of investment and underwriting earnings of
the mutual company (don’t forget that a mutual policyowner is effectively an owner of
the business also). Many believed, particularly stock insurers, t hat these earnings
should not be excluded from corporate income taxation. After all, dividends payable to
stockholders are not deductible by corporations.
Congress did finally assess the situation when it was attempting to determine the
amount of taxation from insurance companies for budgetary purposes, and they
discovered that with a 100% policyowner dividend deduction, a mutual insurer may
have paid little or no tax. Conversely, however, if they did not allow any deductions,
then the legitimate payments to policyowners (as customers, not owners) and which
should be deductible under general tax laws, would therefore be denied to mutuals,
which meant overtaxing those companies.
In order to solve this dilemma, it was determined that the dividend deducti on of mutual
companies would be limited. The machinations of this deduction is beyond the scope of
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this text, but in effect it equalized the taxation with that of the stock companies by a
procedure which actually taxes mutual company’s surplus.
The acquisition of life insurance and the accounting and taxation of acquisition costs,
have always been problematic. In 1990, the Revenue Reconciliation Act created the
deferred acquisition tax (DAC) provision. While complicated, the theory behind it was
that certain first year (or early years) expenses peculiar to insurance companies, such as
commissions, issue and underwriting expenses, etc., should be amortized in order to
better match deductions with revenues.
At this point, it should be pointed out that for many years, life insurance companies had
to provide financial statements under two types of accounting: (1) Statutory accounting
as required by the Department of Insurance and which concentrated more on solvency
than other financial matters, and (2) Generally Accepted Accounting Principles (GAAP)
which uses the same accounting principles as with any other type of business, and
which was necessary for non-insurance financial reporting. The principal difference
between the two was the accounting for acquisition expenses.
Since under Statutory accounting, high “front-end” acquisition costs were considered as
an immediate expense (this is a simplistic explanation) it was frequently necessary for
those smaller insurance companies who experienced rapid growt h, to enter into
financial reinsurance arrangements with larger reinsurance companies who assumed the
drain on the surplus created by these first-year expenses. In essence this was a method
of “borrowing” money to pay these expenses, which would be repaid as profits emerged
from the block of reinsured business, along with interest. This puts the smaller
companies at a disadvantage as their profits would be reduced by the cost of
reinsurance, which would otherwise not have been necessary.
Without going into more detail – and there is considerable detail involved – the DAC
provision of this act created capitalization under GAAP and it specified, by formula, the
amount of the insurer’s general deductions.
Guess what? The DAC tax substantially raised the life insurance industry’s federal
income tax. (Surprise, surprise) Of course the life insurers had to make up for this
unexpected and unwelcome added tax by lowering interest rate credits, dividends and
other non-guaranteed benefits. Of course, it “solved” the difference problem between
GAAP and Statutory accounting.
L I FE I N S U R A N C E C O M PA N Y O R G A N I Z A T I O N
Life insurance companies are usually classified as stock or mutual, although there are
some well-known exceptions, such as the Blue Cross-Blue Shield organizations,
fraternals, savings banks and government plans. A stock insurance company is a
corporation owned by its stockholders, whereas a mutual insurance company is owned
by its policyowners. Worldwide there are more mutual companies, however in the U. S.
there are approximately 1500 stock insurers, and only 100 mutuals (this number has to
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be approximated as there is a lot of activity in company consolidations, purchases and
re-structuring).
A stock company can be owned by other stock life insurance com panies, by mutual
insurance companies, or by non-insurance companies. A mutual company, on the other
hand, is owned by policyowners and cannot be owned by anyone else. Both are
organized as corporations as that is the only type of legal organization that provides
permanence and a high degree of security in respect to the payment of claims.
STOCK INSURERS
A stock company is organized for the purpose of making profits for its stockholders,
and traditionally, issue non-participating and guaranteed-cost insurance policies, and
the policyowners do not share in the profits or savings of the company. Stock insurers
also issue participating policies, so the difference between mutuals and stock insurers is
not as distinct as originally when stock companies could not offer participating plans.
Under a stock ownership corporation, a life insurance company must have a minimum
of capital and surplus to operate before it can obtain a certificate of authority to operate
as a life insurer. During the late 1950’s and early 1960’s, many new insurance
companies were formed and the capital and surplus requirements were quite modest,
depending upon the state and the type of insurance to be marketed. After stock was
sold in the company and the company obtained its certificat e, the stockholders were the
prime source of new business, with many of the new companies issuing a “special”
policy which allowed the policyowner to share in a company profit “as declared by the
Board of Directors,” typically. Due to misrepresentation an d the great number of
mergers and acquisitions among the “special policy” companies, the states enacted strict
regulations and today, such formation and issuance of “special” policies is of interest
only as history.
MUTUAL INSURERS
A mutual company is also a corporation but generally has no capital stock or
stockholders, as the policyowner is both a customer and (in a limited sense) an owner of
the company. The assets and income of a mutual insurance company is owned by the
company and policyowners are generally considered to be “contractual” creditors that
has the right to vote for the Board of Directors. In practice, a mutual insurer is
administered and assets are held for the benefit and protection of the policyowners and
beneficiaries, and the assets are held as insurance reserves, surplus, contingency funds,
or dividends that are distributed to the policyowners as the Board of Directors deem
appropriate.
Mutual companies can, and do, issue non-participating policies, in which case the
policyowners are considered only as customers, as in a stock company.
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It is difficult to form a mutual company, as funds must be available to cover the
expenses of operation, make the proper deposits with the insurance department(s), plus
a surplus and contingency fund, and this must be done before the insurer is able to
collect such funds from its operations. As an example, in New York state, a new
mutual must have applications for not less than $1,000 each, from 1,000 persons, plus
the full amount of one annual premium for an aggregate amount of $25,000 – plus a
cash surplus of $150,000. Obviously, it is not easy to find 1,000 people willing to put
up an annual premium in a company that has not as yet in operation, and there is the
possibility that the company may never get into operation. Therefore, there has been no
formation of a mutual company for several years, and in all likelihood, there will not be
any new mutual companies formed.
HOLDING COMPANIES
Holding companies are financial corporations that own or cont rol (one or more)
insurance companies, investment corporations, broker -dealer organizations, consumer
finance or other financial service firms. Some stock insurers are owned by
conglomerates who are non-financial holding companies that have ownership or control
of several companies in unrelated fields.
A holding company formed by a stock insurer (or more than one stock insurer) is called
an upstream holding company because the holding company sits at the “top” of the
organization, as it is owned by the stockholders, and it can, and usually does, own
subsidiaries. Conversely, a downstream holding company is usually owned by a mutual
company, and the holding company sits in the middle of the corporate structure. It is
owned by the mutual company that sits at the top and owns the subsidiaries.
Insurance departments prefer the downstream type, as with an insurer (usually the
parent mutual company) at the top of the corporate structure, it is regulated by the
insurance departments and therefore presents few problems to insurance regulators.
However, if the downstream holding company is “viable”, i.e., makes financial sense,
the mutual company must be in a very strong position financially in order for the
holding company to make acquisitions. In addition, there are strong regulations
regarding the amount an insurer (stock or mutual) can invest in subsidiaries.
Practically, however, a mutual insurer is limited to making offers for acquisitions only
in cash – an expensive way of acquiring other companies.
Some states have just recently changed their laws to allow a mutual company to form a
mutual holding company with an active stock subsidiary. The stock of the subsidiary is
held by the mutual company. This way, a mutual insurer can make acquisitions and
mergers through the stock subsidiary.
Recently, there have been many mutual companies that have “de -mutualized” primarily
in order to obtain equity capital and other financing alternatives, which has become
necessary because of the growth of the integration of the financial service industry,
making it imperative that the company have an influx of new capital.
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The basic advantage of the stock life insurance company and its upstream holding
company, is that the company can limit the impact of insurance regula tory controls and
the restrictions on noninsurance operations placed on the companies by insurance
regulators; and it allows acquisitions to be made without depleting the company’s
surplus.
OUTSOURCING
Because of the rapid changes in the financial services industry, insurers have been very
active in corporate restructuring and affiliations, and in the way that they do business.
One of newer changes is outsourcing which is the process of “farming out” many of
their administrative and marketing functions.
Many insurers now “brand label” another company’s products, and many will then hire
a third-party administrator to handle claims. Investments can be handled by an
investment banking firm or other similar asset management company. Administration,
which is nearly all handled by computers, is performed by service bureaus. Even
marketing can be accomplished by third-party arrangements, direct marketing, or a
combination of the two. In some situations, this new generation of insurers has been
referred to as “virtual insurers.”
In a sense, insurers have become general contractors, with subcontractors performing
many of their functions. Of course, management must monitor the performance of the
“subcontractors” and this can cause conflict between the insure r management and the
“outside” management, but in reality as more competition is available in the various
“outsourcers,” the less conflict there will be.
HOME OFFICE ORGANIZATION
The organization of a life insurance company is basically the same as for m ost other
financial organizations that collects, invests and disburses funds. There are many ways
of illustrating an organization, with flow-charts, tables of organization, etc., but for
purposes of this text, the “departmental” approach will be used. So me of these
functions are self-defining, and the various levels are not shown in any area of
importance, except for the top levels of authority of course.
The operations of a life insurance company involve three basic functions: sell, service
and invest. Most insurers have seven functional departments, described below (after the
Board of Directors and Executive Officers descriptions):
Board of Directors
The Board of Directors and its affiliated committees are the top level of authority in the
company. In a mutual company they are elected by the policyowners; in a stock
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company they are elected by the stockholders. It is empowered to select the President
and other principal officers, but to delegate to them the authority they need to fulfill
their functions.
Executive Officers
The executive officers are responsible for carrying out the policies as determined by the
Board of Directors. They consist of the Chief Executive Officer, President (they may
be the same person) and various vice presidents who ar e in charge of their department
on a daily basis. Depending upon the size of the company, there are usually several
layers of officers, each with a specified supervisory function.
Actuarial
The actuarial department provides several essential functions. For smaller companies, a
consulting actuarial firm may be used for these functions, and even for the larger
companies, consulting actuaries are used for auditing, product development, and other
services. This department establishes the premium rates, esta blishes and calculates the
reserve liabilities and non-forfeiture values, and any other mathematical operation
needed. They also analyze earnings and determine dividends and excess credit. They
create new policies and forms, and are responsible for fili ng forms with the insurance
departments (if there is no in-house legal counsel to perform thisd function).
The actuarial department conducts mortality and morbidity studies, supervises the
underwriting department in many companies, and works with the ma rketing department
in the design of policies. In many of the larger companies, group and annuity
operations are under the control of the actuarial department. In many smaller
companies, the actuary serves as the executive vice president and is considered the
“number 2” man in the company.
Marketing
Marketing is responsible for the sale of new business, conservation of old business and
certain policyowners’ service, supervises agents, and is responsible for advertising,
sales promotion, market analysis, recruiting and training of agents. This department will
be examined in more detail later.
Accounting
Accounting and auditing functions are under the direction of the vice president and
controller, and establishes and supervises the accounting and control f unctions of the
insurer. They are responsible for any auditing and for tax matters. In most companies,
the operational computers used by the insurer are under the control of this department.
Investment
The investment department, usually under the control of an investment vice president, is
responsible for the company’s investments and is the custodian for the company’s
bonds, stocks and other investments.
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Legal
In addition to all legal matters, the legal department is responsible for regulatory
compliance matters, representation of the company in any court matter, and any and all
other legal matters.
Underwriting
Underwriting has been described in detail in a preceding chapter. The head of this
department is typically a Vice President and Chief Underwriter, although in some
companies they are two different persons.
Administration
The principal function of the Administration department is to provide home office
service to agents and policyowners. They also are responsible for human resources
(personnel), home office planning and other similar functions. The corporate Secretary
is frequently in charge of this operation in addition to responsibility for Board of
Directors minutes, and other company records. The following four areas are typical of
life insurance home office Administration:
Policyowner Service
When Underwriting is finished with its function, Policyowner Service (also called
Policyholder Service) takes over and performs all administrative functions from issue to
termination, including policy issue, premium billing, agent compensation, and in some
companies, claims administration. Not only the agents and policyowners are served by this
department, but also services to beneficiaries are performed. Policyowner Service
departments may be organized by region, by function (reinstatement, policy loans, etc.) or by
product.
Claims Administration
Because there are difference in claims among product – life and health insurance,
for example – claims are usually divided by product. This department is responsible
for obtaining all necessary information about the claim, those making the claim, and
any other interested party; investigation of possible fraud or invalid claims; and
processing claims. Large companies frequently have regional offices to facilitate
claims payments.
Information Systems
The Information systems department has become very important in home office
operations because so much administration of all types is performed on computers,
including management information and operational information. Because of the
need for computers for developing new products and premiums, some information
departments (formerly “EDP” departments) are under the control of the actuarial
departments. Today, so many other operations depend upon computers, the
necessity of having an independent or semi-independent information department is
vital. In some companies, there are two separate operations, one operation which
uses the large “mainframe” computer, and the other which uses PC’s networked
together.
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Human Resources
(Formerly known as “Personnel”) – Human Resources has moved up in importance
in the organization, as the value of using the skills and talents of employees to the
best benefit of the company has become more apparent. In addition to being
responsible for providing the necessary number and type of employees, they are
heavily involved in training and professional development, performance appraisal,
compensation and many other functions. Laws regarding employee -employer
relationships have become more pronounced, so this has also become an important
function of this department.
MARKETING
Marketing has been defined as “the creation of a demand for a company’s products, its
distribution, and services for customers who puchase that product.” (Dictionary of
Insurance Terms, Third Edition) The Marketing Department (or Agency Department), is
the focus of all sales activity within an insurance company, and as a matter -of-fact, the
focus of the company. Without the sales of its product, the company has no reason for
existing, but it isn’t easy.
Depending upon the method of distribution, the Marketing Department personnel varies.
Generally there is a Vice President of Marketing (or similar title), and several other
Assistant Vice Presidents and their assistants. The responsibilities of the “Agency
Secretary” is interesting, as it varies greatly from company to company. In some
companies, this is a secretarial or executive administrative position, while in other
companies, the Agency Secretary is the 2nd most important person in Marketing, and
yet in other companies the responsibilities fall somewhere in between.
There is an old adage that “Life insurance is sold, Property and Casualty insurance is
bought.” Even with all of the changes in the life insurance industry, this is still true
today in most situations.
Life insurance is sold through “distribution channels” and generally speaking, there are
three distribution channels, marketing intermediaries, financial institutions, and direct
response.
Marketing Intermediaries
The marketing intermediaries are individuals who sell life insurance products, usually
on a one-on-one basis and usually for a commission. In North America, 90 percent of
all new individual life insurance sales are marketed in this fashion, by agents and
brokers.
Life insurers fall into two broad classes, those who recruit, train, finance, house and
supervise their agents (agency-building); or, those which rely on established agents for
their sales, (non-agency-building).
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Agency-Building Di stribution
The agency-building distribution systems are career agencies and general agencies,
multiple-line exclusive agencies, home service agencies, or salaried agencies.
Career Agencies usually sell one company’s products, and on a commission basis,
which is the system used by the largest life insurers. With the branch office system, the
agency manager is responsible for the recruiting and training of agents in his territory.
The general agency system accomplishes the same thing as the branch office system,
but on a more independent basis. Many consider this to be a “theoretical approach” in
today’s market, but there are still a significant of highly independent general agents, but
certainly not as many as there used to be. Because of the plethora of new products
being introduced constantly and the administration and training they entail, many
companies have accepted much of the administration and training support previously
provided only the the general agent. The general agent is compensated on a
commission basis, usually on an overriding commission.
Another system is the multiple-line exclusive agency, where the agents are
commissioned, but sell only the products of a multiple-line company. Allstate and State
Farm insurance companies are two examples of this approach. Most of the agents are
multiple licensed and can sell life, health and property & casualty insurance. Over the
past 15 years, the number of these agencies has grown by 16%, probably because of the
expense of maintaining two different type of agencies.
Home Service system is also known as debit, or combination agencies, as they market
the small, debit policies, basically still house-to-house on their “debit.” Originally it
was industrial insurance, with weekly collections. Today it is ordinary insurance (with
typically small face amounts) and premiums either collected monthly, or billed through
the mail. Few companies still exist, and the number of home service agents has fallen
by 76 percent during the past 15 years.
The use of salaried insurer employees is the marketing method of savings bank life
insurance in Connecticut, Massachusetts and New York. Many companies use salaried
employees to market group insurance and who typically are paid a salary plus an
incentive bonus based on certain goals.
(A note regarding the Agency Management. The responsibility of the General Agent or
the Branch Manager is primarily recruiting agents. Thepersonal production of the
General Agent or Manager is usually not of much importance, and since the turnover of
agents is around 25% per year, recruiting is the principal function.)
Brokers
The term, “Broker” in life insurance describes a commissioned sales person who works
independently of the insurer with whom he places business, but he has no particular
production or other similar requirements with the insurer. While most career agents
“broker” business (verb), it is usually for business that is not accepted by the primary
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insurer of the agent because the primary insurer do es not offer a policy of that type, the
business has been declined or heavily rated by the primary insurer, or sometimes the
client wants quotes from more than one insurer.
A broker (noun) can also refer to independent life insurance producers who have no
particular loyalty to any one company, but they specialize in certain products or
markets. They are highly independent and are some of the most knowledgeable of all
agents.
A broker is also a salesperson whose primary product is not insurance, such as r eal
estate agents, automobile dealers, etc.
Personal-Producing General Agents
The personal producing general agent (PPGA) are independent comissioned agents who
usually work alone and market on a personal production basis. There are two types,
traditional and Master General Agent (MGA). With the traditional approach, the
insurer hires experienced life insurance agents with a contract that offers direct
commissions and override commissions, plus an office allowance. The MGA approach
is usually used for a single product, such as universal life or a health insurance product.
Independent Non-life Agents
Independent property and casualty agents sell products for several companies on a
commission basis and many times the companies that they represent will hav e life
insurance affiliates. The agents are encouraged to take advantage of their P&C
clientele as customers for life insurance. Life insurers who have P&C affiliates have
tried for many years and spent a lot of money in training of non -life agents, in order for
them to produce life insurance. Usually the efforts and expense of the life insurers has
been for naught, because, as a general rule, P&C agents simply do not put forth the
sales effort to be successful in life insurance asnd they are uncomfortab le selling an
unfamiliar product, particularly a product so different from their “bread and butter”
products.
Large Producer Groups
Producer groups are independent marketing organizations that specialize in large
premium policies, frequently high substandard business or a specialized product,
annuity, etc., that have special commissions from the insurers. The members must
provide the necessary sales and marketing staff and assistance to the members of the
group. Minimum production is usually required for all members of the group.
Financial Institutions
Life insurance can now be sold by banks, thrifts, credit unions, mutual funds
organizations and investment banks. These are not large volume marketers at this time
as banks are responsible for only 5% of all life insurance but they write 20% of the
annuities. Securities firms are rather new entrants into the life insurance arena, and are
starting to sell a significant share of variable products.
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Direct Response
Direct response, which includes telemarketing and ads run on television, radio and in
newspapers, only accounts for about 2% of total life insurance sales in the U.S.
Proportionately, direct response is the area that generates (probably) the most
complaints by agents and consumers alike because there is no “interface” with agents.
Usually the products are rather simple and originally they were rather basic policies
providing supplemental life or health coverage. However, the science of direct response marketing has evolved to where many forms of life and health insurance are
offered, as well as estate planning and annuities. The clients deal with the insurer by
mail after the sale.
Direct mail is the oldest form of direct-reponse marketing of insurance products, with
names and addresses available from a number of specialty companies that supply
requested lists. In some cases, an organization may be a sponsor, and the insurer will
make an arrangement to offer its products to the membership.
Commercial on-line networks and the Internet are now available to shoppers, with
insurance quotes of several companies provided through the Internet, and many
insurance companies will provide quotes and take an application through the Internet.
Most insurers have a web page on the World Wide Web that can p erform these
functions.
T H E FUT URE O F L I FE I NS UR AN CE
The ownership of individual life insurance in family households over the past several
years, has not been encouraging. In 1960, nearly 75% of all family households owned
individual life insurance, but today, not quite 50% of households do. However, the
number of households that owned group insurance has grown rapidly.
The average age of Americans is increasing and life insurers are having to provide
insurance arrangements to facilitate the needs of an older population. The recent
introduction of accelerated death benefits attest to this. Longevity has increased
substantially and for many, the problem of outliving the assets in retirement is more
important to many, than the problems of premature death.
At the present time, about 60 percent of the costs of health, retirement security and
long-term care is borne by the government. These needs will continue to grow, but the
ability of the government to pay for them at the present levels is quite questi onable. If
the private sector continues to provide for spending for these needs, considerable and
increased financial and political pressure can be anticipated.
Life insurance still is considered as the best method of family protection in case of
premature death of the family breadwinner, but even the definition of “family” can
cloud this consideration. With so many single-parent families, the purpose of life
insurance has to change somewhat in order to provide for children who would be
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orphaned upon the death of their only parent. The importance of life insurance for
children’s education and for retirement, has decreased in the public’s conception in
recent years. Many companies have compensated for this by establishing broker -dealer
firms to help market investment products such as variable life and variable annuities,
universal life and variable universal life, and mutual funds. Today, more than 40% of
the insurance agents in the U.S. are licensed to sell variable products, and more than
half of all individual annuity premiums are from sales of variable contracts.
In respect to retirement and health care, these areas should show increases in the future
because of several factors. Perhaps the most important factor is the fact that the
population is aging, and the “senior citizens” are very security-conscious. The
government has reduced their desire to provide for the full individual security of every
citizen, leading many to become concerned about their own personal financial security.
Another extremely important factor is that corporations will try to assist employees in
becoming more independent in respect to their personal financial security, but at the
employee’s expense. Insurer’s and others in the health care industry, have announced
an average of 15% increase in medical insurance premiums for the year 2002. With the
present political situation, especially with the terrorist war situation, companies are
going to seek and find ways to reduce their own employee benefit costs.
In any event, the life insurer of the future - and not too distant future – will be larger
and more efficient, and will be more market-focused. One of the biggest problems with
the industry as it now exists, is that it is one of the most inefficient industries in the
way that it markets its products. For a variety of reasons, inefficiencies and
competition must be included as major problems, and in addition, profit margins on new
products have been slipping drastically. Many companies have focused on only “high end” markets.
Many medium-sized insurers will grow through normal growth plus mergers and
acquisitions, which is in reality a continuation of the processes initiated several years
ago. Smaller companies will have a difficult time surviving, except for those fortu nate
enough to be in a “niche” market – this too, was forseen at least 15 years ago.
Marketing will continue to be under scrutiny in its efforts to write more profitable
business at a lower acquisition cost. Like it or not, it is inevitable that insura nce
companies will market more through non-agency building distribution channels.
Those companies who have focused on estate and financial planning and insurance
products with tax implications, should continue to do what they have done. This will
still be a market that is dominated by agents and it will continue to use life insurance
and other financial products. It is likely that more agents, financial and estate planners,
will perform their services on a fee basis. The effect on the new 2001 tax law s on
estate and financial planning still remains to be seen, but it is not expected that the
impact will be large after “the dust has settled.” In some fashion, it is also likely that
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life insurance will be more a part of a larger financial service arena, than as a standalone product.
The size of the middle income market will continue and will probably grow. The focus
will still be on needs and marketing organizations will use the Internet, telemarketing,
financial institutions and other types of distribution systems. The products that will be
marketed the most successfully should continue to be interest -sensitive and variable
products, as well as the basic term insurance and traditional cash -value products. The
sale of annuities should continue to grow.
The lower-income, smaller product market will continue to be served by worksite
marketing, direct-response marketing, financial institutions and government programs.
Home service will probably continue, but in a smaller scale, while direct -marketing by
using the Internet for advertising and information sources, including some direct sales,
should continue to grow.
There are over 5 million firms in the United States with less than 100 employees, and
many of them do not have group insurance, retirement plans or business insurance. The
need for insurance continues to be great in this market. Many small companies do not
offer any benefits to their employees or have any business continuation life or health
insurance. Traditionally, smaller businesses are served mostly by career agents, and
this should continue.
Large corporations, on the other hand, will more frequently be served directly by
insurers, as many have had “cost-plus” or administrative-service-only groups which
have proven quite cost effective for the employer and the insurers. There is a trend now
to market products directly to corporate employees, primarily middle -income
employees. This trend will continue to grow and insurance “advisors” and consultants
could play a more prominent role in this trend.
Companies must devise ways to more efficiently deal with agent and field management
compensation. If the companies do not take significant action in these areas, they will
continue to obtain business that they may not want, and at a price th ey cannot afford.
Proper consideration of the agent’s goals in respect to the commission structures, will
determine the future of compensation and distribution.
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STUDY QUESTIONS
Chapter 10
1.
2.
3.
4.
5.
6.
Congress received its power to regulate commerce
A.
between states from the United States Constitution.
B.
within the state (intrastate) from the United State Constitution.
C.
from the state department of insurance.
Typically, the Federal government exercises its authority over the insurance industry by
A.
appointing a new Federal Insurance Commissioner.
B.
Congress holding hearings and “investigating” the industry.
C.
by organizing the NAIC.
The principal purpose of state regulation in the insurance industry is
A.
is to license insurance agents.
B.
to enforce the NAIC Model Unfair Trade Practices Act.
C.
that of solvency of insurance companies.
Life insurance premiums
A.
are not regulated.
B.
are regulated by the NAIC.
C.
and benefits forms are not regulated by the states.
The state insurance department can revoke an agent’s license for
A.
selling a term life insurance policy.
B.
attempting to persuade a policyowner to cancel one policy and by a new one by
using misrepresentation.
C.
establishing a separate bank account for premiums.
Money the insure company receives as premiums is
A.
placed in an unregulated general fund.
B.
used by the insurance company as it sees fit.
C.
placed in either Capital and Surplus, or Reserve investments.
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7.
8.
9.
10.
11.
12.
Most states has some type of guaranty law, pertaining to life and health insurance
companies.
A.
The act covers policyowners who are residents of the state when the insurance
company is determined to be insolvent or impaired.
B.
This guaranty for an annuity owner, covers principal and anticipated interest.
C.
The guarantee limit applies to each policy or contract an individual might have.
Life insurance companies in the United States are taxed by
A.
the federal government, and exempt from the taxation by individual states.
B.
each state, based on net income; gross income less deductions.
C.
both the federal government and state government.
A company that is organized for the purpose of making a profit for it’s stockholder, and
usually the policyowners do not share in the profits of the company, is
A.
a mutual insurance company.
B.
an up-stream holding company.
C.
a stock insurance company.
Which department of a typical life insurance company established the premium,
calculates the reserve and creates new policy forms?
A.
Marketing.
B.
Actuarial.
C.
Accounting.
The U.S. Supreme Court in 1869 ruled that
A.
insurance companies are governed by state law.
B.
the sale of insurance by way of television, was interstate commerce.
C.
foreign insurance companies can be prevented from doing business in another
state by the federal government.
One of the main arguments used by states to maintain the regulation of insurance with the
individual states is to
A.
create political jobs within the department of insurance.
B.
reduce paperwork.
C.
be more responsive to local requirements and needs.
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13.
14.
15.
Today ____________________ still maintain primary responsibility for regulating
insurance.
A.
individual states.
B.
federal government.
C.
state insurance commissioner.
The stated purpose of the _________________ is to maintain and improve state
regulations, ensure reliability of insurers, and the “fair, first and equitable” treatment of
policyowners and claimants.
A.
state legislatures.
B.
the National Association of Insurance Commissioners (NAIC).
C.
state insurance department.
________________ has no particular loyalty to any one insurance company, but
specialize in certain products or markets.
A.
An independent life insurance agent.
B.
A career agent.
C.
An Allstate agent.
Answers to Chapter Ten Study Questions
1A 2B 3C 4A 5B 6C 7A 8C 9C
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10B
11A
12C
13A
14B
15A
GLOSSARY
401(k) Plan A profit-sharing plan established by an employer in which there are three
types of contributions: employer contributions, employee contributions from after-tax
income; and employee salary reduction (elective) contributions.
403(b) annuity A tax-deferred annuity in which an employer sets aside a portion of
the money that would otherwise be part of an employee’s pay.
A
Absolute assignment: See Assignment, Absolute.
Accelerated death benefit: Provisions or riders involving the payment of all or a
portion of a life insurance policy’s face amount prior to the insured’s death because of
some specified, adverse medical condition of the insured.
Accidental bodily injury: A clause stating that a bodily injury must meet one test to
be a covered loss: The result (the injury itself) must be unforeseen or unexpected.
Accidental Death Rider: An attachment to a life insurance policy that provides for
payment of an additional benefit if the insured's death results from an accident as
defined in the rider. Sometimes referred to as double indemnity because many such
riders pay double the face amount of the policy to which they are attached.
Accidental Death and Dismemberment Rider: An attachment to a life insurance
policy that provides for payment of an additional benefit if the insured's death results
from an accident as defined in the rider or payment of an additional benefit for
accidental loss of certain limbs and/or eyesight, depending upon the particular rider.
Accidental means: A clause stating that a bodily injury must meet two tests to be a
covered loss: Both the cause of the injury and the result (the injury itself) mus t be
unforeseen or unexpected.
Accumulation Period: For an annuity, the period during which money is paid into the
annuity and left to earn interest until the liquidation or payout phase begins. Compare to
Liquidation Phase.
Accumulation Units: Funds invested in a variable annuity; the number of accumulation
units purchased depends upon the dollar amount invested and the value of a single
accumulation unit at the time of investment. Investors never have fewer accumulation
units than the number purchased, but the value of the accumulation units fluctuates with
the performance of investments in the separate account. Compare to Annuity Units.
Actual authority or powers: With regard to authority extended to an agent acting on
behalf of an insurance company, the authority that is expressly stated in a contract
between the agent and the insurance company. Also called express authority
Actuaries: Individuals who determine insurance premiums and reserves using their
best estimates of future losses and expenses, with an eye towards competitiveness.
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Adhesion. Contract of. Refers to the characteristic of an insurance policy that requires
one party, the insured/ policyowner, to "adhere" or agree to terms stipulated by the
other party, the insurer, with little or no optio n to negotiate the terms.
Admitted insurer. An insurance company that has been authorized by a state's
insurance department to do business in that state. Also called an authorized insurer.
Adverse selection. From an insurance company's perspective, the selection and
subsequent insuring of too many higher risk insureds as compared to insureds who pose
a lower risk of loss.
Adjustable Premium Whole Life Insurance. See Universal Life Insurance.
Adjusted gross estate. The gross estate less all allowable deductions except bequests
to the surviving spouse and to charities.
Administrator. A person appointed to administer a decedent’s estate.
Agency Authority. Authority to act on behalf of a principal, such as an insurance
company, that the principal grants to its agents-those who represent it. Also called
powers of agency. See Actual, Apparent, Express and Implied Authority
Agent. One who represents and acts on behalf of another known as the principal. In the
insurance business, the agent acts on behalf of the insurance company, selling that
company's policies. Compare to Broker.
Agent's Statement. A portion of an insurance application that is completed by the
agent, providing any information the agent has about the applicant and the agent's
opinion and recommendations about the applicant's insurability and suitability for
coverage.
Aleatory Contract. Refers to the characteristic of an insurance policy that both parties
to the contract do not necessarily offer equal value.
Alien Insurer. From the perspective of an insurance company domiciled in the United
States, refers to an insurance company organized under the laws of another country.
American Agency System. See Independent Agent.
Amount at Risk. In a life insurance policy that accumulates cash values, refers to the
difference between the face amount (death benefit), and the policy's cash value, which
is the pure insurance protection.
Annual renewable term. Term policies with level death benefits and premiums
increasing annually.
Annuitant. The person designated to receive income payments from an annuity during
the liquidation phase.
Annuity. A product marketed by life insurance companies into which an individual, the
annuitant, makes either a single large premium payment or a series of smaller payments
over a longer period known as the accumulation phase, alter which a scheduled flow of
income is paid for the annuitant's lifetime or for other periods according to the annuity
contract.
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Annuity Units: In a variable annuity, the fixed number of units used for dete rmining
the amount of income payments to the annuitant, resulting from the conversion of
accumulation units purchased during the accumulation phase. Once fixed, the number of
annuity units remains level throughout the liquidation phase, but the value of ea ch unit
fluctuates with the performance of investments in the separate account. Compare to
Accumulation Units.
Apparent Authority or Powers: With regard to authority extended to an agent acting
on behalf of an insurer, authority an agent is reasonably beli eved to have from the
perspective of a third party.
Application: In the insurance business, the applicant's request for an insurance
company to provide a life insurance policy, including information about the applicant
that permits the insurer to decide whether to issue the policy as requested.
Assignment: Transfer of an insurance policy's ownership rights and/or benefits from
one person to another.
Absolute: A policy assignment under which all rights and control are fully and
permanently transferred to another person.
Collateral: A policy assignment to a creditor as security for a debt, permitting the
creditor to first recover its outstanding loan if the policyowner defaults on the loan
or if the insured dies before paying off the debt.
Conditional: A policy assignment subject to certain conditions as specified in the
assignment and occurring only if those conditions actually occur.
Partial: A conditional policy assignment under which only a portion of the rights
and/or benefits are assigned.
Assumed interest rate (AIR): The minimum interest rate that an insurance company
has determined the cash value of a variable life insurance policy must earn in order to
cover the cost of insurance.
Attained age: The current age of an insured person or the age the person will be at
some time in the future. Compare to Original Age.
Authorized Insurer: An insurance company that has been admitted or authorized by a
state's insurance department to do business in that state. Also called an admitted
insurer.
Automatic Premium Loan Provision: An optional life insurance policy provision that
allows the insurer to borrow from the policy's cash value to pay a premium the
policyowner fails to pay during the grace period, thus keeping the policy in force. If the
provision is activated, the premium payment is treated as a loan and interest is charged
to the policyowner.
Automatic reinsurance treaty: Where the direct-writing company must transfer an
amount in excess of its retention of each applicable insurance policy to the reinsuring
company immediately upon payment of premium and the issuance of the policy, and the
reinsurer must accept the transfer that falls within the scope of that agreement.
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Aviation Exclusion: A provision commonly included in certain life insurance policy
riders stating that the rider does not apply if death or disability occurs from an aviation
accident unless the insured was a passenger on a regularly-scheduled flight of a
commercial airline.
B
Back-End Loading: A method of charging sales and administrative expenses associated
with a life insurance policy under which no charges are deducted from premium
payments before they are deposited into the cash value account; instead, charges or
loads apply later when certain trams-actions occur. Also see Front-End Loading,
Loading and No-Load.
Bailout: A feature in some annuity contracts permitting the buyer to terminate the
annuity if the interest rate the insurer pays falls below a rate specified in the contract.
Buyer may withdraw all principal and interest earned without paying surrender charges.
Beneficiary: In a life insurance policy, the person or entity designated to receive the
death benefit when the insured person dies.
Contingent or Class II: An alternate or second named beneficiary designated to
receive the death benefit only if the primary beneficiary dies before the insured
dies.
Irrevocable: A beneficiary designation that may never be changed; no policy
transactions may occur without the consent of an irrevocable beneficiary.
Primary or Class I: The first named beneficiary designated to receive the death
benefit when the insured dies.
Revocable: A beneficiary designation under which a different beneficiary may be
named at any time at the policy-owner's option; the most common type of
beneficiary designation.
Binding Receipt: A type of conditional receipt under which the insurance company
agrees to pay a small death benefit if the applicant dies within a specific limited period
of time whether or not the insurance company would ultimately decide to issue the
policy.
Branch Office: Refers to an insurance distribution arrangement whereby the insurance
company owns the office and pays an agent to manage the office and other insurance
company employees. Also called a managerial system
Broker: (noun) One who is in the business of selling insurance, but who represents
clients rather than insurance companies, seeking the best insurance policy for client
needs. Compare to Agent. (verb) The act of submitting insurance a pplications to various
insurers
Business Continuation Insurance: Refers to insurance purchased for the purpose of
funding a buy/sell agreement for business owners. Also called business insurance: Also
see Buy/Sell Agreement
Business Insurance: See Business Continuation insurance.
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Buy/Sell Agreement: An agreement between business partners that if a business owner
dies, his or her interest in the business will be sold to and purchased by specified others
for a predetermined price. Life insurance policies are a common method for funding
such an agreement. Also see Business Continuation Insurance.
Buy term and invest the difference: Where an individual purchases a low-cost term
insurance policy instead of a cash-value policy, and invests the difference between the
premium into a mutual fund or other investment media.
Bypass trust: A trust that holds property not left to the surviving spouse, also known
as a credit shelter trust, non-marital trust and residuary trust.
C
Capital stock and surplus: the excess of company’s assets over its liabilities.
Career agents: Commissioned life insurance agents who primarily sell one company’s
products.
Cash Accumulation Value: The amount credited to a cash value life insurance policy
that the insurer pays interest on, also referred to as cash value Compare to Cash
Surrender Value.
Cash or Deferred Arrangement (CODA): An arrangement whereby an employee
defers receiving a portion of current income to allow the employer to contribute that
portion to a retirement plan, especially a 401 (k) plan. Also called a salary reduction
plan
Cash Surrender Value: In a cash value life insurance policy, the amount of monies the
policyowner would receive if the policy was surrendered. Compare to Cash
Accumulation Value.
Cash Value: See Cash Accumulation Value and Cash Surrender Value.
Cash-value accumulation test: Test applying mainly to traditional cash-value policies
requiring that the cash surrender value not at any time exceed the net single premium
required to fund future contract benefits.
Cash-value corridor requirement: Under tax laws regarding life insurance policies, fulfilled if
the policy’s death benefit at all times is at least equal to certain percentage multiples of the cash
value.
Cash value life insurance: A life insurance policy that includes a savings feature
whereby a part of each premium is paid into an account that builds cash values upon
which the insurer pays interest. The cash value is owned by the policyowner and may be
used as collateral for loans or paid to the policyowner upon surrendering the policy to
the insurer. Also called permanent life insurance
Catastrophe (catastrophic) insurance: Contract that covers multiple insured losses
arising from a single accident or occurrence.
216
Certificate of Insurance: Under a group insurance plan, the evidence of insurance
provided to the group members in lieu of an actual policy, with the policy or master
contract being held by a master policyowner, such as an employer.
Certified Financial Planner (CFP): A designation awarded by the College of Financial
Planning, or one who has earned the designation by meeting certain experience
requirements, completing a specific course of study and successfully passing
examinations on topics related to financial planning services and products.
Charitable remainder trust (CRT): A living, irrevocable tax-exempt trust in which
the donor contributes property to the trust, reserving to himself or herself or someone
else, an income stream from the trust, with the residual trust corpus ultimately passing
to a charity.
Charitable remainder unitrust (CRUT): A trust the pays a fixed percentage of the
fair market value of its assets to the income beneficiary at least annually. Trust assets
are revalued each year, so the income will vary by year.
Chartered Financial Consultant (ChFC): A professional designation awarded by the
American College, or an individual who has earned the designation by meeting
experience requirements, completing a specific course of study and successfully passing
examinations on topics related to financial planning services and pr oducts.
Chartered Life Underwriter (CLU): A professional designation awarded by the
American College, or a life insurance agent who has earned the designation by having
the required experience, completing a specified course of study and successfully
passing examinations on topics related to life insurance company products and
operations.
Classification: The process of assigning a proposed insured to a group of insureds of
approximately the same expected loss probabilities as the proposed.
Close corporation; closed corporation; closely held business: Businesses whose
ownership interests have no ready market. Usually owned and managed by same
person(s), with small number of owners and ownership interest not readily marketable.
Coinsurance plan: A reinsurance plan under which the reinsurer assumes a
proportionate share of the risk according to the terms that govern the original policy.
Collateral assignment: A temporary transfer of only some policy ownership rights to another
person.
Collateral Assignment: See Assignment, Collateral.
Commingling: Holding policy owner’s money in an account with other funds of the
insurer.
Commissioner of Insurance: The person designated to oversee a state's insurance
department and to be responsible for enforcing the state's insurance laws and
regulations, called superintendent of insurance in some states.
Commissioner's Standard Ordinary Table (CSO): See Mortality Table.
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Common Disaster Provision: A provision often included as part of the beneficiary
designation of life insurance policies to resolve the question of whether an insured died
before or after the primary beneficiary when both ultimately die from a common event;
provides for policy proceeds to be held in trust for three months. If the primary
beneficiary is still alive after three months, the death benefit is paid to that person. If
the primary beneficiary dies before the three-month period ends, proceeds are paid to
the contingent beneficiary.
Concealment: By an applicant or insured, the withholding of material inf ormation from
the insurance company in order to gain a benefit that would not have been available had
the insurance company known the concealed facts.
Conditional Assignment: See Assignment, Conditional.
Conditional Receipt: A receipt for premium payment given to the insurance policy
applicant, stating the conditions under which the insurance will be considered to be
effective as of the date of the receipt. Also see Binding Receipt.
Consanguinity: A blood relationship.
Consideration: Refers to an exchange of value in a contract. In an insurance contract,
the policy owner’s consideration is the premium paid and the insurer's consideration is
the insurance protection provided.
Consumer reporting agency: US Fair Credit Reporting Act defines as an inspection
company that collects and sells information about individual’s employment history,
financial situation, credit-worthiness, character, personal characteristics, mode of
living, and other possibly relevant personally identifiable information.
Contestable Period: A specified period, usually one or two years, beginning on the
insurance policy effective date, during which the insurer may challenge or contest
information provided by the applicant. After the contestable period ends, the insurer
may not void the policy. Also see Incontestable Clause.
Contingent beneficiary: See Beneficiary, Contingent.
Contract: A legal agreement that is enforceable if it is between two or more competent
parties, has a specific purpose and that purpose is legal, and value or consider ation is
included as part of the contract. An insurance policy is a contract.
Contributory Plan: A group insurance plan that requires at least a portion of the
premium to be paid by participants in the plan. Participation is optional for each group
member, but a high number, usually at least 75 % of eligible group members must choose
to participate. Compare to Noncontributory Plan.
Convertible Term Insurance: A type of term insurance that permits conversion of the
policy to cash value life insurance within the time limits specified in the policy.
Conversion privilege, Group Life: In some group life insurance plans, a feature that
allows the insured to convert the coverage to individual cash value life insurance policy
upon leaving the group, usually without proving insurability. The privilege generally
must be exercised within 30 or 31 days after separation from the group.
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Corporate Stock Redemption Plan: A method used by the owners of closely held
corporations to allow the corporation to purchase shares of a deceased stockholder's
stock as part of a buy/sell agreement that may be funded by life insurance. Also see
Business Continuation Insurance and Buy/Sell Agreement.
Cost basis: Under income tax law, the sum of the premiums paid of a life insurance
policy less the sum of any dividends received in cash or credited against the premiums.
Cost of insurance: The contributions each insured must make as his or her pro -rata
share of death claims in any one year.
Cost of Living Rider (COLA): A rider that may be added to a life insurance policy
giving the policyowner the option to purchase an additional amount of insurance to help
offset the effects of inflation. The amount of insurance available is tied to the consumer
price index and has a maximum upper limit per year. For whole life policies, the
additional amount is usually provided by one-year term insurance. For universal life
policies, the death benefit simply increases.
Cross-Purchase Plan: A type of buy/sell agreement under which each partner
purchases and owns a separate life insurance policy on every other partner's life and
receives the death benefit if any partner dies. Compare to Entity Purchase Plan.
Credit Life Insurance: A form of group insurance available to creditor-debtor groups
wherein the creditor is the beneficiary of a term insurance policy on the debtor's life;
used to protect the creditor's interest.
Crummey trust: A trust in which the annual $10,000 gift tax exclusion is available
for gifts made to the trust if funds are withdrawn by a benef iciary within a limited
time period.
Current Assumption Whole Life Insurance: See Interest-Sensitive Whole Life
Insurance.
Current Declared Interest Rate: In a flexible premium deferred annuity, the interest
rate the insurer is currently paying and will pa y for a specified period, may be
adjusted at the insurer's discretion and remains in effect for another specified period.
Current Interest Rate: In nontraditional life insurance policies, an interest rate
comprised of both the minimum guaranteed interest r ate specified in the policy and the
excess interest rate which is an unspecified rate in excess of the guaranteed rate. Also,
see Excess Interest Rate & Guaranteed Interest Rate.
D
Death Benefit: In a life insurance policy, the policy proceeds or amount t hat is paid to
a beneficiary when the insured dies.
Death proceeds: The policy face amount and any additional insurance amounts paid by
reason of the insured’s death, such as accidental death benefits and the face amount of
any paid-up insurance or any term rider.
Debit insurance: Any type of insurance sold through the home collection of premium
system of marketing.
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Decreasing Term Insurance: A type of term insurance under which the death benefit
gradually decreases over the term of the policy until it ev entually reaches zero and the
policy expires, often used to cover a homeowner during the period of a mortgage.
Available both as a separate policy and as a rider attached to a cash value life insurance
policy. In some riders, the face amount may decrease to a certain amount at which point
the amount remains at that level until the end of the term, when it abruptly drops to
zero. Compare to Increasing Term Insurance and Level Term Insurance.
Deferred Annuity: A type of annuity under which the liquidation phase is deferred
until some time in the future, with the buyer making flexible annuity premium payments
that accumulate and earn interest until the liquidation phase begins. Also refers to
deferred taxation of interest paid on the annuity. Compare to Immedia te Annuity.
Defined Benefit Plan: A type of corporate retirement plan under which the amount of
the retirement benefit is defined or established in advance according to a predetermined
formula. Contributions are then made with the objective of providing th e predetermined
benefit. Compare to Defined Contribution Plan.
Defined Contribution Plan: A type of corporate retirement plan under which a
specified formula is used to determine the amount of the contribution that will be made
for participants, while the exact amount of future benefits remains unknown. Compare
to Defined Benefit Plan.
Direct Recognition: A principle applied to participating life insurance policy dividend
payments that takes into account the interest rate the insurer earns on an outstanding
loan and the dividend interest rate the company assumes would have been earned on the
borrowed cash value if that amount had not been borrowed. When direct recognition is
applied, policies without loans outstanding are paid a higher dividend than those wi th
loans outstanding.
Direct response: Distribution channel in which the customer deals directly with the
insurer without any intervening intermediary or firm.
Direct Writer: Refers to an insurance distribution system wherein insurance companies
deal directly with potential clients rather than using agents.
Disability: Inability to perform gainful employment. Total disability is defined in one
of two ways for insurance purposes: (1) inability to perform the individual's previous
work or work for which the individual is qualified by training or experience or (2)
inability to perform any type of gainful employment.
Disability Income Rider: A type of rider that may be attached to a life insurance policy
to provide a monthly income if the insured becomes disabl ed according to the insurer's
definition of disability.
Disintermediation: When a person borrows at one rate and can invest the loan
proceeds at a higher rate.
Dismemberment: Refers to the loss of certain parts of the body. In the accidental death
and dismemberment rider, typically refers to the loss of certain limbs and is used
inclusively for loss of eyesight when such loss is covered. Also see Accidental Death
and Dismemberment Rider.
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Distribution system: Any of several different methods by which life insurance products
are marketed.
Dividend: In a participating life insurance policy, a refund to the policyowner of excess
premiums paid when an insurer experiences more profit than anticipated due to savings
on operating expenses, improved mortality or higher investment returns.
Dividend options: In a participating life insurance policy, any one of several options
under which the policyowner may choose to use dividends, such as: cash dividend,
premium reduction, paid-up policy, paid-up additions, accumulation at interest or oneyear term insurance.
Domestic insurer: From the perspective of a given state, an insurance company
organized and operating under the laws of that particular state. Compare to Alien
Insurer and Foreign Insurer.
Domiciled: In reference to an insurance company, indicates the location of the home
office, the state where the insurance company was organized, e.g., "domiciled in Ohio."
Double Indemnity Rider: See Accidental Death Rider.
Downstream holding company: Formed by a mutual insurance company and sits in
the middle of the inter corporate structure.
E
Education IRA: A tax-favored trust of custodial account created to pay the cost of a
beneficiary’s education.
Eligibility period: Under a group insurance plan, a short period after em ployees first
become eligible to participate in the plan, often 30 days, during which employees must
enroll in order to acquire coverage without proving insurability.
Employee Retirement Security Act (ERISA): Federal law enacted to protect the
interests of participants in employee benefit plans as well as the interests of the
beneficiaries.
Endorsement: Technically and historically, a provision added to an insurance policy by
being written on the policy form. Often used inter -changeably with the term “rider” to
indicate a provision added by attachment to the policy.
Endowment: A promise to pay a certain sum in case the insured dies within the term of
the policy or the same sum if the insured survives the period.
Entity Purchase Plan: A type of buy/sell agreement under which a business
partnership as an entity purchases and owns a life insurance policy on the life of each
partner. If a partner dies, the death benefit is paid to the partnership entity. Compare to
Cross-Purchase Plan.
Errors and Omissions Insurance (E&O) : A form of professional liability insurance
that insurance agents may purchase to cover their liability to others for inadvertent
mistakes agents might make, causing loss to clients.
221
Escheat: To transfer all of a decedent’s property to the state when there is no Will and
no relatives exist.
Estate Tax: See Federal Estate Tax.
Estoppel: Refers to the principle that a party, who has waived a right, either expressly
or by implication, cannot later request reinstatement of that right.
Excess Interest Rate: In nontraditional life insurance policies, an unspecified rate of
interest, established at the insurer's discretion and subject to change, over and above the
guaranteed interest rate, usually related to a known financial index such as the yield on
U.S. Treasury securities. Also see Current Interest Rate and Guaranteed Interest Rate.
Excess interest: Whole Life Insurance. See Interest-Sensitive Whole Life Insurance.
Exclusion Ratio: Under the rules for liquidating an annuity, refers to a method fo r
determining what portion of each annuity payment represents return of premium, and is
therefore untaxed, and what portion represents interest, and is subject to taxation.
Executive bonus plan: An arrangement under which t he employer pays for
individually issued life insurance for certain selected employees.
Express Authority or Power: See Actual Authority or Power.
Extended Term Insurance: A non-forfeiture option that maintains the policy's death
benefit amount by using the cash value to pay for it as t erm insurance for whatever
period the available cash will provide at the insured's attained age. Any outstanding
policy loan is deducted from the death benefit amount and from the cash value before
determining the length of the term.
F
Face Amount: The dollar amount shown on the front or face of a life insurance policy,
indicating the death benefit-the amount that will be paid to beneficiaries if the insured
person dies. The amount actually paid might be different if a policy loan is outstanding
or if riders or other provisions increase or decrease the death benefit.
Facultative reinsurance: Reinsurance basis under which each application is
underwritten separately by the reinsurer.
Fair Credit Reporting Act: A federal law designed to protect consumers by p roviding
that they be notified if they are being investigated by an investigative agency and
establishing certain procedures that allow consumers to challenge and correct errors in
information kept on file about them.
Family coverage: Usually refers to a combination of permanent and term insurance
under which the family breadwinner is covered by cash value life insurance and other
family members' lives are covered by term insurance.
Family income coverage: A combination of permanent and term insurance providing
that, when the insured dies, the cash value life insurance death benefit is paid in a lump
sure followed by installment payments of the term insurance as income to the survivors.
Under some policies, the installment income from the term insurance is p aid first and
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when the income period expires, the lump sum benefit from the cash value life
insurance is paid.
Federal Estate Tax: A tax the federal government assesses at death on estates valued at
more than $600,000. Life insurance proceeds can avoid federal estate taxation if the
insured has no incidents of ownership and if the estate is not the beneficiary of the
policy.
Fiduciary: Refers either to people entrusted to handle matters involving others'
financial affairs or to the actions of people so entrusted. Life insurance agents are
considered to have fiduciary responsibilities in their relationships with clients.
First to die insurance: Pays the face amount of the policy on the first death of one or
two or more insureds covered by the policy – also known as joint life insurance.
Fixed amount temporary annuity: An annuity liquidation method that guarantees
income payments of a specified amount only until the annuity funds are depleted, rather
than for the annuitant's lifetime
Fixed-amount option: An annuity certain with the income amount fixed.
Fixed Annuity: See Flexible Premium Deferred Annuity.
Fixed period temporary annuity: An annuity liquidation method that guarantees to
pay income for a specified period of time, with the amount of each income pa yment
calculated to extend over that period, rather than for the annuitant's lifetime.
Fixed-period option: An annuity certain with the time period fixed.
Flexible-Premium Adjustable Life Insurance: See Universal Life Insurance.
Flexible Premium Deferred Annuity (FPL): An annuity purchased by means of
premiums that are flexible in both amount and frequency of payment and for which
payout is deferred until some future date. Deferred also refers to deferral of interest
taxation until payout. Also called fixed annuity
Flexible-Premium Variable Life Insurance: See Variable Universal Life Insurance.
Foreign insurer: From the perspective of a given state, an insurance company
operating within that state, but organized under the laws of a different state. Compare
to Alien Insurer and Domestic Insurer.
Fraternal Insurance Company: A type of insurer organized on a nonprofit basis solely
for the benefit of its members; may not issue stock; must have elected officials, a lodge
system and ritualistic work. Also called fraternal benefit societies and fraternal orders
Fraud: In regard to insurance, refers to any illegal act, including misrepresentation or
concealment, designed to deceive the insurance company in order to gain a benefit.
Free Look Provision: A life insurance policy provision required by most states,
allowing the policyowner to inspect the policy for a specified period of time, often 10,
15, 20 or 30 clays, and returns the policy to the insurer, if desired, for a refund of the
entire premium.
Front-end loading: A method of charging sales and administrative expenses against a
policy by deducting a certain percentage from each premium payment before the
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payment is credited to the cash value account. Also see Back-End Loading, Loading and
No-Load.
G
GAAP reserves: Life insurance reserves that are calculated using the insurer’s realistic
expectations for morbidity, mortality, persistency, and investment return on a net -level
premium basis.
General Agent (GA): A person operating within a life insurance distribution system as
an independent business person rather than an employee of an insurer, under a
contractual agreement with one or more insurance companies to sell their products.
General agents usually hire other agents and share in their commissions.
General partnership: A partnership in which each partner is actively involved in the
management of the firm and is fully liable for partnership obligations.
Generation Skipping Transfer Tax (GST): Tax levied when a property interest is
transferred to persons who are two or more generations younger than the transferor.
Grace period: In a life insurance policy, refers to a stipulated period of time, usually
30 or 31 days, after the premium due date, during which the policyowner may pay the
premium and keep the policy in force.
Graded premium: A method of charging premiums for life insurance policies under
which the amount of premium is relatively low at the beginning of the policy period and
gradually rises over the years to a certain point, at which time the premiums reach a
level that is maintained for the duration of the policy
Gross estate: The value of all property or interests in property owned or controlled by
the deceased person.
Gross premium: The premium amount a policyowner actually pays based upon
mortality rates, assumed interest on investments and operating expenses. Compare to
Net Premium.
Group Insurance: Various insurance plans made available to people who are members
of a common group, such as employer-employee groups, multiple employer-employee
groups, organized unions, associations and creditor- debtor groups. The employer or
other entity is the master policyowner and administers the plan on behalf of the group
members.
Group permanent insurance: A group contract under which benefits, usually
including a life insurance feature, are funded by a level-premium group annuity contract
issued to the employer with certificates of coverage given to the employees.
Guaranteed Insurability Rider: An attachment to a cash value life insurance policy
that guarantees the insured may purchase additional amounts of insurance without
proving insurability on specified option dates in the future, with the option ending when
the insured reaches an age stipulated by the insurer, often age 40. Specifies minimum
and maximum amounts that may be purchased. Rates are at the insured's attained age.
Also called purchase option rider.
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Guaranteed interest rate: In a cash value life insurance policy, a relatively low
specified interest rate the insurer guarantees will be paid on the accumulating cash
values. Also see Current Interest Rate and Excess Interest Rate.
Guideline level premium: Part of income tax law under which a premium is computed
using interest at the greater rate of 4% or the rate guaranteed in the contract.
H
Holding company: Financial corporations that own or control one or more subsidiary
companies.
Home Office: Refers to the primary location of an insurance company in the state
where the insurer was organized and operates.
HR-10 Plan: See Keogh Plan.
Human life value: A measure of the actual future earnings or values of services of an
individual, the capitalized value of an individual’s future net earnings after subtracting
self-maintenance costs, such as food, clothing and shelter.
I
Immediate Annuity: An annuity purchased with a large single premium, permitting
income payments to begin as soon as the annuitant desires; insurers often allow the
annuitant to defer the first income payment for up to five years. Always a single premium annuity funded by one large lump sum deposit. Also called Single Premium
Immediate Annuity.
Impaired Risk: See Substandard Risk
Implied authority or powers: With regard to authority extended to an agent acting on
behalf of an insurer, authority that is implied, although not expressly granted, by the
agent's contractual agreement with the principal.
Incontestable clause: A life insurance policy provision specifying a certain period of
time, usually one or two years from the policy's effective date, after which the insurer
may no longer challenge or contest any statements or information from the applicant
that Would allow the insurer to void the policy.
Increasing Term Insurance: A type of term insurance, typically available only as a
rider to a cash value life insurance policy, providing for an ever-increasing amount of
insurance during the specified term. The increased death benefit resulting from
increasing term may be paid to beneficiaries either as a refund of premiums paid for the
term rider or as a return of the cash values, in addition to the face amount.
Indemnity: A policy in which the insured suffering a loss covered under the policy,
are entitled to recover an amount not greater than that which would be necessary to
place the insured in the same pre-loss financial position.
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Independent Agent: An individual who operates under an insurance distribution system
as an independent, self-employed person, rather than as an employee of an insurance
company, and who is appointed by and represents any number of insurance companies
that pay commissions to the agent for sales of their products. This method of marketing
insurance is also called the American Agency System.
Indeterminate premium: A life insurance policy premium that fluctuates as the
interest rate changes.
Individual life insurance: Policy written on the life of a single person as differentiated
from group insurance that is written on many lives. Compare to Group Insurance.
Individual Retirement Account/Annuity: A tax-favored retirement plan available only
to individuals and their spouses who meet certain legal requirements for establishing
such plans. Maximum deductible amounts are specified according to income, phasing
out entirely at specified income levels. Also see Spousal IRA.
Industrial insurance: Life and health insurance policies issued to individuals in small
amounts, usually less than $2,000, with premiums collected on a weekly or monthly
basis at the home of the policyowner.
Inflation protection: Ensures that the benefit amount increases with the cost of living.
Initial reserve: The reserve at the beginning of the policy year, which equals the
terminal reserve for the preceding year, increased by the net -level annual premium for
the current year.
Inspection Company: See Consumer reporting agency.
Insurability: Refers primarily to medical and health factors, but also to a variety of
other characteristics examined by an insurance company to determine whether a
particular individual is one whose life the insurance company is willing to insure.
Insurable interest: When an individual can reasonably expect to receive pecuniary
gain from that person’s continued life, or conversely, if he or she would suffer financial
loss on the person’s death. Expectation of monetary loss that can be covered by
insurance
Insurance: A device to spread the cost of financial loss among many people by
transferring the cost through an insurance company so the financial loss to anyone
individual is small.
Insurance adviser: One who provides advice about selecting appropriate insurance
products to members of the public in exchange for a fee. Not employed by or having an
agency contract with an insurance company.
Insuring clause: In a life insurance policy, a provision stating the general promises of
the insurer to pay the death benefit when the insured dies
Inter vivos: A trust that is created during life, also known as a living trust.
Interest option: A settlement option in which the proceeds remain with the insurer and
a guaranteed amount or interest earned on those proceeds are paid to the beneficiary.
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Interest-out-first Rule: An Internal Revenue Service rule that applies to premature
withdrawals from annuities, requiring that if the cash value of the annuity is greater
than the premiums paid at the time of withdrawal, the withdrawal will b e taxed entirely
as interest to the extent that the cash value exceeds the premiums paid.
Interest-Sensitive Whole Life Insurance: A nontraditional type of life insurance
designed to reflect interest rates in the marketplace. Specific features vary among
insurers, but many include a minimum guaranteed interest rate as well as a fluctuating
current interest rate. Some policies have indeterminate premiums, while others are
fixed. Some may allow reduction of the death benefit in lieu of premium increases, also
called excess interest whole life and current assumption whole life.
Intestate: A person who dies without a valid Will or without having made a complete
disposition of his or her property.
Irrevocable beneficiary: See Beneficiary, Irrevocable
Irrevocable life insurance trust (ILIT): An insurance policy on the grantor’s life
owned by an irrevocable inter vivos trust with the policy proceeds payable to the trust
who is the beneficiary.
Irrevocable trust: A living trust in which the grantor permanently relinquishes
ownership and control of the trust property.
J
Joint and Last Survivor Annuity: An annuity liquidation method that pays an income
to two annuitants while both are living then continues payments of the same amount to
the survivor after one annuitant dies. Also called joint and survivorship annuity
Joint and One-Half Survivor Annuity: An annuity liquidation method similar to the
joint and last survivor annuity except when one annuitant dies, the survivor's income
payment is reduced to half the amount that was paid when both were living. Similar
annuities may be written for different proportions, such as two -thirds or three-fourths.
Joint and Survivorship Annuity: See Joint and Last Survivor Annuity.
Joint Annuity: Any of several types of annuity liquidation methods that provide joint
payments to two annuitants.
Joint Life Annuity: A type of joint annuity liquidation method under which income
payments are made as long as both annuitants are alive, but cease when either one dies,
with no survivorship or death benefits paid. (Rarely written)
Joint tenancy with right of survivorship: Property owned by two or more persons and,
on the death of any owner, his or her ownership interest passes automatically to the
survivors.
Jumping Juvenile Policy: A life insurance policy written on the life of a juvenile,
usually a child underage 15, with a small death benefit that rises abruptly at a specified
age, usually 21, to a much larger amount, often five times as much as the original
amount. The insured need not prove insurability when the neither benefit increases, nor
does the premium changes. Also called junior estate builder
227
Junior Estate Builder: See Jumping Juvenile Policy.
Juvenile Insurance: A life insurance policy written on the life of a juvenile as defined
by the insurer, usually a child under age 15.
K
Keogh Plan: A qualified retirement plan available to self-employed people and their
employees and often funded with life insurance or annuities. Participants must adhere to
specified maximum contributions. May be either a defined benefit or a defined
contribution plan. Also called HR-10 Plan
Key Employee Insurance: An insurance policy purchased by a business to cover the
life of an employee who is considered vital to the financial success of the business and
who may or may not be an owner or officer. If the employee dies, the death benefit is
paid to the business. Also called key person insurance
L
Lapse rates: A measure of the proportion of policyowners who voluntarily terminate
their insurance during a year.
Lapsed policy: A life insurance policy that has terminated because of failure to pay the
premium.
Law of large numbers: A principle that states when statistics are derived from a large
population, the more reliable the assumed statistical probabilities will be; the basis of
life insurance in terms of insuring a large enough pool of people to be able to predict
the probability of deaths occurring.
Legal reserve: Insurance company funds held separately or kept in reserve in order to
pay obligations the insurer has assumed; exact amounts required are determined by law.
Legal Reserve Stock Company: See Stock Insurance Company.
Level premium: A premium amount that remains the same throughout the life of an
insurance policy.
Level Term Insurance: A type of term insurance under which the amount of insurance
available is the same or level throughout the policy period.
License: State-issued document certifying that an individual is permitted to solicit and
sell insurance in a particular state.
Life expectancy: Based upon mortality tables, the average estimated length of life
remaining for a person at any given age.
Life income option with period certain: The most popular life income option – the
installments are payable for as long as the primary beneficiary lives, but should this
beneficiary die before a predetermined number of years, installments continue to a
second beneficiary until the end of the designated period.
228
Life Insurance: Life insurance is a device to spread the cost of financial loss resulting
from death from an individual to a group through an insurance company by transferring
the cost so the financial loss to any one individual is small.
Limited partners: Partnership having at least one general partner and one or more
limited partners who are not actively engaged in partnership management and who are
liable for partnership obligations only to the extent of their investment in the
partnership.
Limited Payment Life Insurance: A type of cash value life insurance policy that
requires payment of premiums only for a limited number of years as stipulated in the
policy. At the end of the limited payment period, the policy remains in force for the
insured's lifetime with no further premium payments required.
Liquidation phase: For an annuity, the period during which the annuitant receives
periodic income payments that systematically depletes the funds in the annuity.
Compare to Accumulation Phase
Living Will: A legal instrument which sets forth the wishes of the individual as to the
use of life-sustaining measures in cases of terminal illness, prolonged coma, or serious
incapacitation.
Loading: Charging sales and administrative expenses to purchasers of financial
products, including life insurance policies and annuities.
Long-term care insurance: Insurance that covers physical or mental incapacity that
prohibits the insured from partaking of activities of daily living.
M
Marital deduction: Deduction of the value of property left to a surviving spouse.
Marketing: Providing of products well suits to consumer’s needs through effective and
appropriate distribution channels.
Mass marketing: (Also called Mass Merchandising) Coverage for a group of
individuals under one policy, usually all members belongs to a particular company,
union or trade association.
Master contract: Under a group insurance plan, a policy issued to the one charged with
administering the plan, such as an employer. Also called master policy
Material misrepresentation: See Misrepresentation, Material.
McCarran-Ferguson Act: Federal law exempting insurance from federal anti-trust
laws and reinforcing state rights to regulate the insurance busi ness. Also called Public
Law 15
Medical Information Bureau (MIB): A medical information clearinghouse created and
supported by member insurance companies. Receives and retains files of consumer
medical information provided by member companies and discloses that information
only to members. Consumers have the right to request disclosure of information in their
229
MIB files, with medical information disclosed only to a physician to explain to the
consumer.
Misrepresentation: Providing inaccurate or misleading information. For life insurance
purposes, refers specifically to information provided by the applicant when attempting
to secure insurance coverage or by an agent in any situation.
Misstatement of age: A policy provision stating that if the insured’s age is found to
have been incorrectly stated, the amount of insurance will be adjusted to be that which
would have been purchased by the premium, had the correct age been known.
Material: For insurance purposes, a misrepresentation that affects or would have
affected the insurer's decision to issue the policy.
Managing General Agent (MGA): An independent insurance wholesaler who contracts
insurance agents with insurers the MCA represents, for the purpose of selling the
insurers' products to consumers. Also called marketing general agent
Mass Merchandising: As a life insurance distribution system, the practice of dealing
directly with clients for the marketing of group insurance products as opposed to
individual insurance products.
Modified coinsurance plan: A reinsurance coinsurance treaty with a provision that
requires the reinsurer to pay the ceding company a reserve adjustment, with the net
effect of making the arrangement a yearly renewable term reinsurance agreement.
Modified endowment contract (MEC): A life insurance policy which was entered into
after June 20, 1988, that meets the IRC Section 7702 definition of life insurance, but
fails the seven-pay test.
Modified premium: A life insurance policy premium that is set at a very low fixed
amount for three or four years, after which the amount is raised to a much higher level
and remains at that level for the duration of the policy.
Monthly debit ordinary: Ordinary life insurance policies which are typically written
in the $5,000 to $25,000 range, with premiums collected monthly at the policy owner’s
home.
Mortality rate: Refers to the average number of people of a given age who are
expected to die each year.
Mortality table: A life insurance table that shows mortality rates-the average number
of every 1,000 living people of a given age from zero to age 100, who are expected to
die each year. One such table, used to compute legal reserves, is the Commissioners'
Standard Ordinary Table or CSO, which is updated periodically and bears the issue
year of the latest update.
Mortgage insurance: A life insurance policy purchased for the purpose of paying off a
home mortgage if the insured dies. Decreasing term insurance is often used for this
purpose, but any type of life insurance policy may be used.
Multiple Employer Trust (MET): A group of small employers who have grouped
together in order to obtain group insurance benefits typically available only to larger
groups.
230
Mutual life insurance company: A form of insurance company organization under
which the policyowners also technically own the company. May issue participating
policies that allow policyowners to share in dividends, when declared. May not issue
stock. Compare to Stock Insurance Company.
N
National Association of Insurance Commissioners (NAIC ): An organization of
insurance commissioners and superintendents that promotes communication about
insurance regulation and practices and recommends model laws related to i nsurance in
all states for the purpose of helping standardize laws and practices.
National Association of Securities Dealers (NASD): National organization of
companies that sell securities, including insurance companies that sell variable
products, with whom insurance agents must be registered as representatives in order to
sell products that are considered securities.
Net amount at risk: The actual amount of pure life insurance protection, which is
calculated as the difference between the policy reserve (at that point) and the face
amount.
Net premium: The premium determined by calculating; a mortality rate and assumed
interest in overall insurance company investments; not the premium paid by the
policyowner, which also considers the insurers operating exp enses. Also see Gross
Premium.
No-Load: Refers to an arrangement whereby sales and administrative fees are not
directly deducted from premiums; instead, the insurer recoups expenses by taking a
percentage of current earnings.
Non-Admitted Insurer: From the perspective of a particular state, an insurance
company that has not been authorized to do business in that slate. Also called an
unauthorized insurer
Noncontributory plan: A group insurance plan under which participants in the plan are
not required to pay any portion of the premiums. The plan must cover 100% of eligible
employees.
Non-forfeiture Options: Options available for receiving the cash value of a life
insurance policy the owner is no longer going to keep in force. They include: receiving
cash, using the cash value for a paid-up policy of a lesser amount or purchasing
extended term insurance.
Non-forfeiture provision: A provision in an insurance policy which stipulates the
options available under a cash-value policy if the policyowner elects to terminate the
policy and explains the basis or method used to determine these optional values.
Non-participating policy: A type of policy that does not share in any dividends that
maybe paid by the insurance company providing the policy. Compare to Participating
Policy.
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Non-proportional reinsurance: A reinsurance agreement wherein the reinsurer pays
a claim only when the amount of the loss exceeds a specified limit. (Also known as
excess-of-loss coverage)
Non-resident agent: An agent doing business in a state other than the state where the agent is
licensed and resides.
O
Ordinary Life Insurance: See Whole Life Insurance.
Original age: For insurance policies, the age of the insured when a policy was
originally issued on the insurers life. Compare to Attained Age.
Outsourcing: Hiring an independent “outside” company to perform specific tasks.
Own occupation: A clause that determines that an insured is totally disabled when
they cannot perform the major duties of their regular occupations
P
Paid-up policy: A life insurance policy for which no further premium payments are
due contractually but the policy remains in effect.
Partial Assignment: See Assignment, Partial.
Participating policy: A type of policy that shares in any dividends that may be paid by
the insurance company providing the policy. Compare to Non-Participating Policy.
Partnership: A voluntary association of two or more individuals for the purpose of
conducting a business for profit as co-owners.
Payment mode: The frequency with which insurance premiums are paid, such as
monthly, quarterly, semiannually and annually.
Payor Rider: A rider attached to a life insurance policy, usually on the life of a
juvenile, providing that premium payments will be waived if the person responsible for
paying premiums dies or becomes disabled, or in some cases, only if the person dies.
Pension plan: A plan established by an employer specifically to provide retirement
benefits for employees. May be a qualified plan by meeting IRS requirements to receive
certain tax advantages. May be either a defined benefit or a defined contribution plan,
and must conform to a formula to determine either the amount of benefits or the amount
of contributions
Peril: A cause of a disability or death of a person(s).
Permanent Life Insurance: Life insurance intended to remain in force for the entire
life of the insured and build cash values that are available to the policyowner for policy
loans or if the policy is terminated.
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Per Capita beneficiary designation: An arrangement to handle situations where there
is more than one primary beneficiary. If one of the primary beneficiaries dies before
the insured dies, it provides that any primary beneficiary’s still living divide the entire
policy proceeds equally.
Persistency rate: The ratio of the number of a group of policies that continue coverage
on a premium-due date to the number of policies that was in force as of the preceding
date.
Personal-Producing General Agent (PPGA): A self-employed insurance agent who
operates similar to a general agent, but does not usually hire other agents. Compare to
General Agent.
Per Stirpes beneficiary designation: An arrangement to handle situations where there
is more than one primary beneficiary and if one of the primary beneficiaries dies before
the insured dies, it provides that any primary beneficiaries still living receive their
original shares and the share of the deceased primary beneficiary passes on to that
deceased beneficiary's survivors.
Planned premium: The rate at which insurance companies bill, according to the
request of the policyowner, in order to overcome the concern that policyowners may
inadvertently allow their policies to lapse. (Also known as target premium)
Policy form number: Legal designation used by an insurance company when filing a
specific policy with the state insurance department.
Policy loan provision: A provision in a life insurance policy under which insurers
must make requested loans to policyholders according to specified limitations.
Policy reserves: The amounts necessary for the fulfillment of contract obligations as to
future claims. The present value of future claims.
Policyholder (Policyowner): The person or entity who pays a premium to an insurer in
exchange for an insurance policy. In this text, polic yholder and policyowner are the
same.
Policy Summary: A summation of selected features of a life insurance policy prepared
and attached to the policy by the insurer for delivery to the policyowner/insured.
Portfolio reinsurance: Reinsurance of specific blocks of insurance policies.
Powers of Agency: See Agency Authority.
Preferred risk: For life insurance underwriting purposes, one who qualifies for the best
life insurance rate a particular insurer offers. For some insurers, refers to the nonsmoker
category. Not all insurers have a preferred risk class. Compare to Standard Risk and
Substandard Risk.
Premium: For an insurance policy, the amount an insured pays in order to acquire and
keep the insurance in force.
Premium deposit rider: An additional policy feature that allows the policyowner to
deposit amounts to pay future premiums.
Premium Tax: See State Premium Tax.
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Primary Beneficiary: See Beneficiary Primary.
Pre-need funeral insurance: Life insurance policies that are designed &/or sold to
fund a pre-arranged funeral.
Present value: The principal amount that must be invested at the present time in order
to accomplish some objective in the future.
Principal Sum: In the accidental death and dismemberment rider, refers to the face
amount of the life insurance policy to which it is attached, when specifying the portion
of that amount that will be paid for various types of dismemberment losses.
Probate: The (judicial) process by which a Will of a deceased person is authenticated
to a court.
Proceeds: The death benefit of a life insurance policy.
Producer: A term used to refer collectively to people involved in selling or soliciting
life insurance, including agents, brokers and solicitors. Some states issue a producer's
license rather than having different licenses for different types of personnel.
Professional reinsurer: An insurer whose exclusive business is reinsurance.
Profit-sharing plan: A corporate plan designed to share company profits with
employees in the form of a retirement plan. May be a qualified plan by meeting IRS
requirement s to receive certain tax advantages
Proportional reinsurance: Reinsurance agreements in which the reinsurer and the
ceding company share premiums and claims on a risk in a specified proportion.
Purchase Option Rider: See Guaranteed Insurability Rider.
Q
Qualified plan: Any retirement plan that meets the requirements of the Internal
Revenue Code to be eligible for special tax treatment.
Qualified terminable interest property: Property passing from the decedent in which
the surviving spouse is entitled to a lifetime income payable at least annually, from the
property.
R
Rebating: A regulated practice forbidden by most states, involves offering a potential
insurance buyer something of value other than the policy to induce the buyer to
purchase the policy. Includes splitting commissions with the buyer, refunding part of
the premium, giving valuable gifts or any other valuable inducement
Reciprocal agreement: An agreement between two state insurance departments
whereby each state's licensed resident agents are permitted to sell insurance in the other
state without qualifying for an additional license, instead operating as a non -resident
agent in that state. Also see Non-Resident Agent and Resident Agent.
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Reduced paid-up insurance: An option on a life insurance policy that permits the
policyholder to use the cash surrender value as a net single premium, to purchase a
reduced amount of paid-up insurance of the same type as the original policy, exclusive
of any term or other riders.
Re-entry feature: A feature of some automatically renewable term policies permitting a
lower renewal rate if the insured elects to have a medical examination and proves
continuing good health.
Refund Annuity: An annuity liquidation method that provides a lifetime income for the
annuitant and also guarantees the return of an amount equal to premiums paid, either to
the annuitant or to survivors if the annuitant dies before receiving income equal to
premiums. Beneficiaries can receive a lump sum cash refund of unreturned premiums or
installments of the same amount the annuitant was receiving.
Reinstatement provision: A provision in a life insurance policy that gives the
policyowner the right to reinstate a previously lapsed policy under certain condition s.
Reinsurance: The purchase of insurance by an insurance company.
Reinsurer: An insurance company that assumes the risk of another insurance company.
Renewable Term Insurance: A type of term insurance that permits the insured to
renew the policy without proving insurability when the stipulated term expires. Most
insurers renew for a like term automatically unless the insured specifically refuses
renewal, with premium determined at the insured's attained age. Option to renew
expires at an age specified by the insurer, typically 60, 65 or 70. Also see Re-entry
Feature.
Replacement, Policy: Refers to replacing an existing life insurance policy with another
policy. While not necessarily illegal, a replacement made without providing the
policyowner with a complete and accurate comparison of the two policies and the
advantages and disadvantages of replacement is called twisting, which is illegal.
Representation: In an insurance application, statements made by the applicant which
are believed, but not guaranteed, to be true.
Reserve: An amount determined conservatively to be sufficient to meet future losses
and contingencies and any incurred but not paid obligations. A reserve is a liability for
the insurance company.
Resident Agent: An agent licensed in and doing business in the state of residence.
Compare to Non-Resident Agent Also see Reciprocal Agreement.
Retired lives reserve (RLR): In group insurance, a reserve that is accumulated by an
employer prior to retirement of an employee that will be used to pay premiums on term
insurance after the employee retires.
Reverse split dollar plan: An insurance policy with the pure death protection payable
to the corporation and death proceeds equal to the cash value, payable to the
employee’s beneficiary.
Revocable Beneficiary: See Beneficiary, Revocable.
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Revocable trust: A living trust that the grantor of the trust can change or terminate as
they wish, and can regain ownership of the property.
Rider: An attachment to an insurance policy that changes or adds provisions not
included in the original policy. There is an additional charge for riders added at the
insured's option to provide additional benefits for the insured. Also called an
endorsement
Risk: Uncertainty of financial loss; term used to designate an insured or a peril insured
against.
Risk corridor: In a life insurance policy, refers to the minimum amount at risk that
must be maintained over and above the policy's cash value in order for the policy to
continue to be treated as life insurance for tax purposes. Also called tax corridor
Roth IRA: An individual retirement account (IRA) in which withdrawals after age 59½
are completely free of income tax provided the account has existed for at least five
years.
S
Salary Reduction Plan: See Cash or Deferred Arrangement and 401 (k) Plan.
Savings Bank Life Insurance: A type of life insurance provider operating only in the
states of Connecticut, Massachusetts and New York and offering relatively limited
amounts of life insurance.
Second to die insurance: Life insurance policy that insures the lives of two or more
persons, and that pays the death proceeds only on the second or last to die.
Section 303 Stock Redemption: A partial redemption of corporate stock, permitted by
Section 303 of the Internal Revenue Code, which can be used as the basis for a buy/sell
agreement funded by life insurance. Also see Buy/Seri Agreement.
Securities: Financial instruments that are evidence of debt, such as stocks and bonds,
which pose a risk of loss to the buyer. Includes certain life i nsurance products, such as
variable life insurance and variable annuities, whose financial performance depends
upon the performance of securities investments
Securities and Exchange Commission (SEC): Federal body having regulatory
authority over the sale of securities and securities-based products, including variable
insurance products.
Separate account: The cash value account for variable life insurance or variable
annuities, comprised of the portion of premiums invested in securities, but required to
be kept separate from the insurance company's general investment account.
Settlement Options: The several options available to life insurance policy beneficiaries
for receiving the death benefit. If the death benefit is not paid in a lump sum,
beneficiaries may receive: only the interest by leaving the principal with the insurer;
regular income payments of a fixed amount; income for a fixed period of time; a
lifetime income.
236
Seven-pay test: A method that determines if a life insurance policy qualifies for th e
tax treatment of a life insurance policy, which it would if the cumulative amount paid
under the life insurance policy at any time, exceeds the cumulative amount that would
have been paid had the policy’s annual premium equaled the net -level premium for a
seven-pay life policy.
Single Premium Deferred Annuity (SPDA): An annuity purchased with a large onetime lump sum premium rather than by flexible premium payments and for which
liquidation is deferred until sometime in the future.
Single Premium Immediate Annuity (SPIA): See Immediate Annuity.
Single Premium Variable Life Insurance: A variable life insurance policy purchased
with a large one-time lump sum premium rather than by periodic premium payments.
Single Premium Whole Life (SPWL) insurance: The life insurance policy is paid-up
from inception with a single payment, and the policy has immediate and substantial
cash values.
Sole proprietorship: A business, unincorporated, owned by one person who usually
also manages the business.
Solicitor: In the life insurance business, one who acts on behalf of an agent or broker to
locate potential insurance buyers, but who does not actually sell insurance.
Spendthrift Clause and Spendthrift Trust: A clause included in some life insurance
policies and a corresponding trust established to receive the death benefit of a life
insurance policy in order to protect the proceeds from creditors. Periodic income
payments are made from the trust to the beneficiary. Laws differ among the state
concerning the extent of protection such trusts actually provide.
Spousal IRA: An Individual Retirement Account/Annuity established to receive
contributions for both a wage earner and spouse, and thus eligible for a slightly larger
annual contribution.
Standard non-forfeiture laws: Laws that requires cash value life insurance policies
to state the mortality table and rate of interest used in calculating life insurance nonforfeiture values to be provided by the policy, as well as a description of the method
used in calculating the values.
Standard risk: For life insurance underwriting purposes, one who poses an average risk
of dying at certain points in the future and forms the basis upon which basic life
insurance premiums are determined. This represents most insureds. Many insurers have
different standard risk rates for smokers and nonsmokers.
State premium tax: A tax assessed by some states against each insurance premium;
where applicable, included in the insured's premium payment and sent to taxing
authorities by the insurer.
Step-rate Premium: A premium that increases to reflect the insured's attained age at
designated tunes rather than remaining level; may refer to a renewable term premium.
237
Stock insurance company: A form of insurance company organization under which
stockholders, not policyowners, own the company and share in profits. Stocks and/or
bonds may be offered to the public for purchase and new issues may be offered to raise
capital. Also called legal reserve stock company. Compare to Mutual Insurance
Company.
Stock Redemption Plan: See Section 303 Stock Redemption.
Straight Life Annuity: An annuity liquidation method providing lifetime income
payments to the annuitant. When the annuitant dies, all payments stop regardless of how
much of the annuity accumulation has been liquidated. There are no survivor benefits.
Straight Life Insurance: See Whole Life Insurance.
Substandard Risk: For life insurance underwriting purposes, one who poses a greater
than average risk of loss to the insurance company and thus pays the highes t rates. Also
called impaired risk and special class risk
Suicide Clause: A standard provision in life insurance policies stipulating a period of
time, usually one or two years, after the policy effective date during which, if the
insured commits suicide, the death benefit will not be paid, but premiums will be
returned to the survivors.
Superintendent of Insurance: See Commissioner of Insurance.
Surrender Charge: In an annuity, a gradually-decreasing percentage of the annuity
value charged against the annuity if the buyer surrenders the policy any time during a
specified number of years immediately following the annuity purchase. Disappears after
from five to 20 years, depending upon the insurer. Specific percentages differ by
insurer.
Surrender value: See Cash Surrender Value.
Survivorship life insurance: A life insurance plan wherein two or more lives are
insured and death proceeds are paid only on the death of the second or last to die (also
known as second-to-die insurance)
T
Tax Sheltered Annuity (TSA) : A special type of annuity, available only to tax -exempt
organizations specified in the Internal Revenue Code as 403(b) and 501(c)(3)
organizations, through which an employer uses a portion of what would otherwise be
the pay of the employee, to purchase the annuity.
Term Insurance: A life insurance policy with no cash values that is written for a
specified period of time, after which the policy expires without paying a death benefit if
the insured is still living.
Terminal reserve: The reserve at the end of any given year.
Terminally ill: When an individual has been certified by as physician as having a
medical condition that can reasonably be expected to result in death within 24 months
or less.
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Testator: A person who makes a Will.
Transparency: Used in interest-sensitive products which assures that accurate
information needed by customers, intermediaries, rating agencies and government
agencies will be readily available.
Trust: A legal agreement wherein one party transfers property to another party, and the
second party (trustee) holds the legal title and manages the property for the benefit of
others.
Twisting: In life insurance marketing, the illegal act of inducing an insured to replace
an existing life insurance policy with a policy the agent is selling, without providing the
insured with an accurate and complete comparison of the two policies and an
explanation of the advantages and disadvantages of replacement.
U
Unauthorized insurer: From the perspective of a particular state, an insurance
company that has not been authorized to do business in that state. Also called a nonadmitted insurer
Underwriting: The process of selection and classifying a potential insured, by
examining and investigating an insured to determine whether or not the insura nce
company is willing to provide the insurance requested and on what basis.
Unfair Claim Practices: A group of provisions related to insurance claims and
representing one of the unfair trade practices prohibited by law; may differ from state to
state, but usually based upon a model law recommended by the National Association of
Insurance Commissioners.
Unfair Trade Practices: A group of provisions specifying certain actions prohibited by
state law in insurance transactions and usually based upon a model la w recommended
by the National Association of Insurance Commissioners.
Uniform Simultaneous Death Act: A law adopted by most states providing that, if the
insured and the primary beneficiary appear to have died simultaneously and there is no
evidence that the primary beneficiary outlived the insured, it will be assumed that the
insured died last, making the life insurance policy's proceeds payable to the contingent
beneficiary.
Unilateral contract: Refers to a characteristic of a life insurance policy whereb y only
one party to the agreement must fulfill the contract; in this case, the insurer is required
to pay the death benefit as long as premiums are paid, whereas the policyowner has the
option to stop paying premiums and give up the insurance.
Universal Life Insurance: A life insurance policy characterized by flexible premium
payment and an adjustable death benefit, as well as payment of a higher interest rate on
cash values than traditional life insurance policies. A low rate is guaranteed and there is
potential for a higher rate. Also called adjustable premium whole life and flexiblepremium whole life
Universal Variable Life Insurance: See Variable Universal Life Insurance.
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Upstream holding company: A holding company formed by one or more stock
companies.
Utmost Good Faith, Contract of. Refers to the characteristic of a life insurance policy
that causes each party to rely upon the good faith of the other party in being truthful
and keeping the promises made as part of the contract.
V
Vanishing Premium: A premium-payment arrangement whereby after the policy has
been in force for a certain period of time, dividends and/or interest earned on cash
values are used to pay premiums to keep the policy in force and no additional premium
payments are required from the policyowner.
Variable Annuity: An annuity characterized by no guaranteed amount of return during
the accumulation or liquidation phases since the amount of annuity funds available
depends upon the performance of investments in the separate account; s ubject to
securities regulation.
Variable Life Insurance: A life insurance policy that has a minimum guaranteed death
benefit that may be greater as the result of fluctuations in the separate investment
account; cash surrender values may fluctuate, no inte rest rate is guaranteed; subject to
securities regulation.
Variable Universal Life Insurance: A life insurance policy characterized by
combining features of both variable and universal life policies. Provides a variable and
adjustable death benefit, a minimum guaranteed death benefit, flexible premium
payments; subject to securities regulation. Also called flexible-premium variable life,
Universal Life II, and Universal Variable Life
Viatical Settlement: An arrangement whereby a policyowners sells a life insurance
policy to a viatical settlement firm.
Viatical Settlement firm: A specialized company, or a group of investors, that
purchases life insurance policies, usually from terminally ill individuals.
Viator: A person who sells their life insurance policy to a Viatical Settlement firm.
W
Waiver: Voluntary relinquishment of a privilege or right.
Express: A waiver that is knowingly and intentionally given.
Implied: A waiver given by implication rather than knowingly or intentionally
given
War exclusion: A provision in a life insurance policy that excludes coverage if the
insured’s death occurs under certain military conditions.
Waiver of Premium rider: An attachment to a life insurance policy that allows the
policy to continue in force without further premium payment if the insured becomes
disabled and unable to work; disability is defined in the rider.
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Warranty: A statement that is guaranteed to be absolutely and literally true; important
in insurance as contrasted with representations on an application s ince information on
the application is considered to be a representation rather than a warranty.
Whole life insurance: Traditional type of permanent cash value life insurance under
which premiums are paid and the policy exists for the entire life of the in sured (usually
age 95, 98 or 100, but insurers may use other ages). Also called straight life and
ordinary life
Will: A legal declaration of an individual’s wishes as to the disposition to make of
his/her property on death.
Y
Yearly renewable term: Term policies with level death benefits and increasing
premiums.
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LIFE INSURANCE
BIBLIOGRAPHY
BOOKS, REFERENCE & TEXT
The Handbook of Estate Planning
Robert Esperti & Renno Peterson
McGraw Hill Book Co., NY
Principles of Insurance Production
Peter Kasicky, et al
Insurance Insitute of America, 1986
Life and Health Insurance, Thirteenth Edition
Kenneth Black, Jr., & Harold D. Skipper, Jr.
Prentice Hall, 2000
Black’s Law Dictionary
Seventh Edition
West Publishing Co., 1999
The New Life Insurance Investment Advisor
Ben G. Baldwin
McGraw Hill, 1994
Variable Universal Life
Dearborn Financial Publishing, 1999
Financial Planning Process, 7 th Edition
Pictorial Publications, 1997
Life, Health and Contracts
Noble Continuing Education
Private printing, 1996
Dictionary of Insurance Terms, Third edition
Harvey W. Rubin, Ph.D., CLU, CPCU
Barron’s Educational Series, 1995
Financial Planning with Life Insurance Products
James C. Munch, Jr.
Little Brown & Co. 1990
242
Legal Aspects of Life Insurance
Edward Graves & Dan McGill
American College, 1997
Ernst & Young’s Personal Financial Planning Guide
Robert Garner, et al
John Wiley & Sons, Inc. 1999
Law and the Life Insurance Contract
Life Office Management Association
McGraw Hill 1986
Business Insurance
Carolyn Mitchell
Dearborn Pub. May 2001
Principles of Insurance: Life, Health and Annuities, 2d Edition
Harriet Jones & Dani Long
Life Office Management Association, 1999
PERIODICALS
Life Insurance Selling
Oct., Nov. 1998, January through October 1999, Jan., Feb. 2000, and January
through September 2001.
National Underwriter
Various articles, 1999, 2000, 2001
INTERNET ARTICLES
401 (k) – Single Premium Life Insurance
http://wwww-e.analytics.com/fp17.htm
Variable & Fixed Annuities
http://www.e-analytics.com/fp30.htm
Keogh Plans
http://www.e-analytics.com/fp33.htm
Tax Treatment of Variable Annuities
http://www.variableannuityonline.com/free/vatal.cfm
Estate Planning, MFS Fund Distributors. mfs.com 8/14/99
243
Changes in Federal Gift & Estate Tax. wmop@mindspring.com
Several excellent articles from Recer Estate Services. Recer.com
Roth IRA. rothirainc.com
How the Stock market Affect Annuities
insure.com/life/annuity/stock market.html
Variable Life
variableannuityonline.com/vlife/vlwhat.cfm
Financial Planning – GE Center for Financial Learning
financiallearning,com/financial_life_events/building_basics.html
Insure.com’s Retirement Roundtable
insure.com/life/roundtable99/index.html
Equity-indexed Annuities, The best thing since sliced bread?
insure.com/life/annuity/eiamain.html
How Much Money Will You Need When You Retire
e-analytics.com
Roth Conversion IRA Retirement Plan
roth-ira-conversion.com/
401(k) and 403(b) Retirement Plans
financialplan.about.com/finance/financialplan/msub401k.htm
Publications, government and private, 2001 Tax Act:
http://www.house.gov/rules/1836cr.pdf.
http://www.cigna.com/professional/pdf/CPA_0601.pdf
http://www.ebia.com.weekly/articles/401k010531TaxAct.html
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